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An Exceptional Bond Fund For Improving Risk-Adjusted Portfolio Performance

Summary The Vanguard Short-Term Corporate Bond Index ETF is everything I would hope for in a short-term corporate debt exposure. The ETF has low volatility and low correlation with other important investments. The credit quality is respectable without being so high that it eliminates most of the yield. Using this fund as part of a diversified portfolio makes it shine. The Vanguard Short-Term Corporate Bond Index ETF (NASDAQ: VCSH ) is simply a great fund. I wish I could start more articles out with comments that are this positive. This fund is simply great. The yields are severely limited since this is short term debt with respectable credit quality, but the ETF on the whole is just exceptional when it comes to being part of an effective portfolio. Credit The following chart shows the credit quality breakdown. When it comes to a corporate bond fund there are two ways that I like to see the weightings. Either I would want a junk bond fund or I would want one with a credit breakdown similar to this. Personally, favor combining a fund like this with quite a few other bond funds to create a more complex group of bond holdings. Duration The following chart breaks down the duration of the funds. Holdings are almost all less than 5 years and usually more than 1 year. Again, this is a solid choice. If an investor wants to load up on even shorter term bonds, there are funds designed specifically for that. It is difficult to find a useful yield level on those ultra-short bonds so this is a reasonable portfolio composition. Sector The following chart breaks down the sector allocation: This sector allocation may seem absurd if an investor looks at numbers without reading the names. The names of the sectors indicate that rather than breaking down the market into all the corporate sectors, Vanguard is containing several other bond sectors that are not relevant to corporate debt. It wouldn’t make sense for this fund to have an allocation to foreign debt issues or MBS. My hypothetical portfolio, shown lower in the article, picks up those allocations through other ETFs. A Hypothetical Portfolio I put together a very simple sample portfolio using Invest Spy. Due to some of the ETFs being newer the sample period is limited to a little over two years. (click to enlarge) This hypothetical portfolio is weighted to 60% equity and 40% bonds. To break that down the weights from the equity section are 30% total market index (NYSEARCA: VTI ), 10% equity REITs (NYSEARCA: VNQ ), 5% Utilities, 5% Consumer Staples (NYSEARCA: VDC ), 10% International Equity. The bond section is holding 10% in junk bonds (NYSEARCA: JNK ), 5% in extended duration treasuries (NYSEARCA: EDV ), 5% in emerging market government bonds (NASDAQ: VWOB ), 5% short term corporate debt , 5% in short term government debt (NASDAQ: VGSH ), 5% in mortgage backed securities (NASDAQ: VMBS ), and 5% in intermediate-term corporate bonds (NYSEARCA: BIV ). This portfolio won’t be perfect for hitting the efficient frontier, but it should beat the vast majority of real portfolios investors are using on a risk adjusted basis. If long term rates were higher I would have used a higher weighting for long duration bonds due to their exceptionally correlation to major equity classes. My disclosure already states it, but I’ll reiterate that I am long VTI and VNQ. Annualized Volatility When measuring risk adjusted returns for a portfolio the most efficient method is usually to use the Sharpe ratio. For that ratio we are taking the total return annualized return and subtracting the risk free rate. Then we divide the resulting number by the annualized volatility. The problem is that this metric is only really known after the fact. Predicting the level of returns in advance is problematic but correlations and relative volatility are more reliable over time than returns. Within the chart investors can see the annualized volatility of each holding as well as the resulting annualized volatility for the portfolio. While some holdings have higher annualized volatility scores, such as EDV, the ETF makes up for that by having negative correlation to a few of the equity holdings. As a result, the ETF only contributes .6% of the total risk in the portfolio. VCSH has an annualized volatility of 1.8%, which is not bad at all. Once we adjust for correlation the risk contribution is extremely low. That means VCSH fits extremely well in this kind of hypothetical portfolio. The expected returns are not going to be very strong since this is short term corporate debt, but for an investor trying to achieve superior risk adjusted returns relative to the SPDR S&P 500 Trust ETF ( SPY), this is a great holding. It will usually underperform SPY, but it will result in material reduction in total portfolio risk. Correlation I want to dive a little deeper into the correlation statistics. The table below provides the correlation across each of those ETFs which should make it very quick to see which ones are work very well together. When a correlation is shown in the tan color it indicates a negative correlation which is very attractive for reaching the efficient frontier. You’ll notice that quite a few of the bond funds have negative correlations to VTI and the S&P 500. Since VTI and SPY have a correlation ranging between 99% and 99.9% depending on the measurement period, it should not be surprising that those two funds have very similar correlations to other holdings. Here is the correlation table: (click to enlarge) Conclusion When the ETF is placed within the context of a portfolio that is heavy on U.S. equities it looks like an intelligent way to reduce the overall risk of the portfolio. When it comes to generating alpha, I’ve often told investors that the secret to reaching alpha is to focus on reducing risk. Most other investors are already focused on trying to maximize their returns and many will take on more risk than they can handle. Focusing on risk reduction reduces the incentives for an investor to sell off after a big loss and makes it easier to generate alpha relative to the S&P 500 because it is easier to reduce risk through superior diversification. Disclosure: I am/we are long VTI, VNQ. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.

Microsoft Corporation (MSFT) Crumbles: Stock Falls by 5.7%

Microsoft Corporation ( MSFT ) saw a big move last session, as the company’s shares fell by nearly 6% on the day. The move came on pretty good volume too with far more shares changing hands than in a

Time To Short The VIX?

Summary Historically, we haven’t reached breakout status for the VIX. Many global factors are at play. This is possibly an economic event leading to longer periods of backwardation. The last week in volatility has been very exciting to say the least. The VIX Index logged the highest ever one week gain in percentage terms. Again, we immediately had the pundits out yelling short the VIX. I saw posts on Thursday around the web urging readers to short the VIX. Someday, this will end poorly for them and the people that heed their advice (Friday should have been a good sign). Below we will examine whether this really is a good opportunity to short in terms of risk verses reward. I am always analyzing my risk and reward in a trade. Once the reward begins to outweigh the risk, then I will begin planning my entrance. I believe risk and reward are currently the same. Essentially giving you a 50/50 chance of profiting right now. More to come on that later. Let’s start by reviewing the past month for the Proshares Ultra VIX Short-Term Futures ETF (NYSEARCA: UVXY ) and the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ). You can clearly see the effect of last week in the chart. Similarly here is a chart showing the front-month VIX futures contract. As you know (or should know), UVXY does not track the VIX Index, which is currently at 28. This is a large divergence from the front month futures contract. Remember futures trade independent of the market and the VIX Index. This, in my opinion, means that investors aren’t that concerned yet over a crash in the markets. U.S. economics continue to be neutral to positive. However, global economic fears are beginning to spillover. Just six months ago analysts were touting emerging markets, now look at them. For more on how UVXY profited during the 2008 and 2011 VIX events, check my library here on Seeking Alpha. UVXY will benefit from the current levels of backwardation if they can hold for a longer period of time. See below: (click to enlarge) Backwardation at 6.5% roughly means that UVXY will increase 13% in one month’s time if futures stay the exact same price, minus any fund fees. Now we know futures never stay the same, but this is just an easier way to think about contango and backwardation. Backwardation hit over 20% in 2011 and over 40% in 2008 (backtested). Backwardation is the only way UVXY will hold profits over longer periods of time. Again, check my library for articles on backwardation if you are unfamiliar with the term. Historical Numbers I know many of you are very excited about this spike. However, let’s compare this event to past events. Backwardation: (click to enlarge) At 6.5%, this puts backwardation higher than a normal political event. If you remember in my last article we discussed the differences between an economic and political event. This event, so far, is leaning towards an economic event. Economic events are usually much more drawn out. I told you earlier in the year I was looking for a backwardation event higher than 10%. I believe this could become that event. More about this in the conclusion. Futures Levels Futures levels directly impact UVXY. Here is a longer-term chart of those futures levels: Yes, futures are towards the higher end of what they have been over the past three years. However, this is nowhere near breakout status. Futures generally trade lower than the VIX Index during a spike. For reference however, here is the VIX Index dating back to 1990: Conclusion The best entry points in the VIX futures, for shorting UVXY or going long XIV, occur during periods of prolonged economic turmoil. Yes, we logged the highest ever one week rise (by percentage) in the VIX Index. However, I feel we still have room to rise. Those pundits that are shouting short the VIX may be right or may be wrong, that is not the point of this article. I like a lot of reward for the risk I am taking. I don’t see the VIX returning to 12 anytime soon. We are in a prolonged period of slower economic growth. Eventually that was going to catch up to valuations and the U.S. stock market. We have recessions in Brazil and Chile. We have slowing growth in China, which should be your biggest concern. The Greek drama is off the table for now but you still have a case of many countries within the Euro that have very high debt levels and growth that isn’t high enough to sustain it. Here in the U.S. we also have unsustainable debt levels but can print however much money we desire. Ultra low rates have helped lower the burden of interest payments but the lack of decent inflation has backed The Fed into a corner in regards to raising rates. A September rate hike would spook the markets. The fact we don’t see higher inflation even given the ultra low interest rates is a realization and confirmation of the slow growth era. For now, I will remain on the sidelines and hope conditions continue to worsen. If I miss the opportunity, I am certainly okay with that. My total VIX portfolio is up a healthy amount YTD and I am fine with locking in those gains instead of gambling it away. This is not to say that I am not salivating at the mouth for a chance to short the VIX. Here is what I am currently watching, in order of importance: The Fed (what’s going to happen with rates, I view any delay as a negative confirmation on the U.S. economy) Economic data out of China (can the government stop the decline this time?) U.S. employment data (weekly) Devaluation of the Yuan (will it continue?) Economics in South America Political/debt situation in Europe (Greece drama is on the back burner for now) I am not backing up the truck to short this spike. We may get a bounce in the U.S. next week but economic problems always take a while to resolve themselves. I would short the VIX with caution if you feel that is the right thing to do. Call spreads (more info on my blog), stop losses, and not jumping all in help to limit your risk/reward. Risk management is needed here, otherwise you are just gambling. I wish you the best this week and know that I will be following the situation and posting updates when needed. It will be an interesting week! Should conditions deteriorate even more, I might begin shopping for a small position. With school starting, I would only be looking for a more long-term position since I am busy during the day. I just need more reward for the current level of risk. Donate to my classroom! I am trying to create a 360 degree mathematics classroom. Much of the money I make here on Seeking Alpha is donated back into public education, something I really believe in. My students come from the highest area of poverty where I live. They are truly great students with a desire to better themselves. My job is to level the playing field and give them a chance to succeed. One tool I used last year at a different school was a 360 degree mathematics classroom. It is a great tool for math teachers. A lot of what I teach lays the foundation for financial literacy and success in post-secondary education. Here is the link if you would like to help fund my 360 degree boards. Use the code SPARK at checkout (until 8/27) and your donation will be matched 100% up to $100. Currently they are running another promotion from The Gates Foundation that will also match 100% up to $1,000 (which would be more than what is needed). That code is JUMPSTART but will only be available for a limited time. You can’t use both codes. All donations are tax deductible and will make an actual difference in the education of some great kids. We are getting close to funding. Thank you! Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in UVXY over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.