Tag Archives: portfolio

How Can I Pick The Best Dividend ETF?

Summary Dividend ETFs are tools for building a better retirement. Finding the right exchange traded fund for an individual investor requires knowing how the investor wants to use the tool. Investors that want to dollar-cost average into the ETF will need to consider the impact of trading costs. When an investor is looking at the dividend yield, they need to calculate the yield across the entire portfolio. Investors should aim to have a healthy margin of safety to facilitate a buy-and-hold strategy. Many investors have recognized that they need to create a dividend portfolio with strong yields and low risks to protect their lifestyle in retirement. ETFs with strong dividend yields are the quickest way that investors can get access to a diversified group of high dividend companies that will provide a growing stream of income for them to live on without having to use up the principle. Drawing down the portfolio eventually leads to a death clock as investors are forced to wonder if they will outlive their money. Building a portfolio around a high-quality ETF is one way to prepare for a long and happy retirement. It Starts With You When you want to find the right dividend ETF, you need to recognize that you are looking for a financial tool. Remembering that the ETF is simply one tool will make it easier to find the best one for you. There are certain factors that will always be important, but the importance of each factor depends on the investor. Buying Strategy Are you making one lump purchase, or are you planning to dollar-cost average into the position over time? The answer is very important, because it determines which aspects of the investment will be most important in analyzing your long-term costs of owning the tool. If you intend to buy all of your shares this month with a large pile of cash, then trading commissions (generally under $10) will be largely irrelevant. On the other hand, if you are planning for a retirement in 20 years and intend to dollar-cost average into the ETF by buying once every week, every two weeks, or each month, trading commissions will be an important consideration. If you fall into the category of frequently making small purchases, then you will want to either prioritize ETFs you can trade for free from your current brokerage, or consider changing brokerages if necessary. Personally, I fall into this category. On average I make about three acquisitions a month through various accounts. I hardly ever sell a high-quality ETF, but I like to be able to make small purchases on a consistent basis. Expense Ratios The expense ratio is a very important factor for the long-term investor. If you follow the simple “buy and hold” strategy, which I endorse, the expense ratio can become a big deal when your holding period stretches from a few years to decades. If you are holding these funds in a taxable account, selling one ETF to buy a different one could incur capital gains taxes. Therefore, I prefer larger funds with a solid history of operating at low costs. In general, expense ratios less than 0.25% are reasonable, and ratios less than 0.13% are excellent. Net or Gross The net expense ratio is what investors actually give up from the fund each year. Some advisors will say that the net expense ratio is the only one that matters, but the gross expense ratio gives investors an idea of where expense ratios might go in the future. If you’re buying an ETF with a low net expense ratio and a high gross expense ratio, it would be better to have the fund in a tax advantaged account so you can change ETFs if the ratio changes significantly. Liquidity and Spreads If you’re going to buy shares in exchange traded fund, you should look into the liquidity and the spread. In general higher levels of liquidity and lower spreads will occur together. A large spread is like an increase in the trading commissions because it will increase your effective costs for each share you buy or sell. So long as the spread is regularly very small, weaker liquidity might not seem like a problem. If the investor is certain they will not need access to the principle at any point, then the weaker liquidity shouldn’t be too much of an issue. On the other hand, if you are not fully insured and might suddenly need access to a large amount of cash, it would be unwise to choose an ETF with poor liquidity. Dividend Yields and the Margin of Safety When you’re buying a dividend ETF, one of the first things you need to ask is whether the dividend yield is going to be sufficient for your needs. When an investor buys into the fund, they should be looking at the dividend yield on their entire portfolio. If the investor is wisely including treasury securities as part of their portfolio, they may have a weaker portfolio yield. Since the ETF will be a major source of income, investors may want to use it as a core piece of their portfolio and allocate between 25% and 60% of their wealth to the ETF. Therefore, they should look at the dividend yield on the ETF. However, simply looking at the number listed for “dividend yield” is insufficient. Investors should pull up the “dividend history”. When investors look at the dividend history, they should consider whether the fund pays monthly or quarterly. If the fund pays quarterly, do you feel comfortable managing your living expenses on a 3 month period rather than monthly? The next factor is looking at the dividends to determine if they have been cut on an annual basis at some point. If the fund has a long track record, investors can see how the fund performed during 2007. Remember that the goal of buying a high quality income ETF is being able to have a steady source of income without listening to the news. If dividends are cut during a recession, investors may be forced to “create dividends” by selling off shares. Under Modern Portfolio Theory selling shares is a perfectly acceptable way to generate extra dividends. Under Behavioral Portfolio Theory, the reality is that human psychology encourages the investor to sell off too many shares at the bottom of the correction. Margin of Safety When an investor is determining the yield they need from their investment to create a strong enough portfolio yield to cover their living expenses, they should ensure that there is a healthy margin of safety. Whether the dividend cut comes from the ETF or from other holdings in the portfolio, the investor needs enough income to know they can cover their expenses without being kept awake at night worrying about their portfolio. The more volatile the dividend history of the ETF, the larger the margin of safety should be. Investors using BDCs (Business Development Companies) or mREITs to strengthen their portfolio yield will need a larger margin of safety because those sectors have dramatically more dividend risk than a high quality dividend ETF.

A Simple SPY Top-Off Portfolio

Summary A one-third UPRO, two-thirds cash portfolio mimics SPY (with some small tracking error and a net 0.32% expense ratio). Putting the two-thirds cash allocation in a short-term bond ETF like BSV allows you to recoup the 0.32% expense ratio, plus earn a little extra. Since UPRO’s inception in 2009, not including trading costs, the UPRO/BSV top-off portfolio has generated a CAGR of 15.3%, compared to SPY’s 14.3%. Going back to 1994, a 3x SPY/short-term bond portfolio has beaten SPY in 21 out of 22 years, with an average 3.1% annual outperformance. For S&P 500 investors, I see little downside to implementing a UPRO/BSV portfolio to consistently beat SPY. Background I’ve written a few articles on combining leveraged ETFs with cash or the underlying index to realize portfolios with certain properties (see for example Build Your Own Leveraged ETF ). There are a few neat things you can accomplish: Achieve any leverage between 0 and the highest multiple leveraged ETF available. Achieve a leverage multiple of an existing ETF by combining cash with a higher multiple leveraged ETF, potentially reducing your net expense ratio. Achieve net leverage of 1 by holding for example one-third of your money in a 3x leveraged ETF, and the remaining two-thirds in cash. The last point leads to the natural question: If I can mimic the SPDR S&P 500 Trust ETF ( SPY) while tying up only 33% of my available balance, why not put the remaining 67% to work in a low-risk fund that generates a few extra percentage points in growth every year? One-Third UPRO, Two-Thirds BSV The ProShares UltraPro S&P 500 ETF (NYSEARCA: UPRO ) is a leveraged ETF that aims to multiply daily S&P 500 gains by a factor of 3. It has an expense ratio of 0.95%. The Vanguard Short-Term Bond ETF (NYSEARCA: BSV ) is a short-term bond fund with an expense ratio of 0.10%. Let’s take a look at how a one-third UPRO, two-thirds BSV portfolio would have performed over these funds’ mutual lifetimes. (click to enlarge) Sure enough we get a nice little top-off with the UPRO/BSV strategy. The compound annual growth rate was 14.3% for SPY, 15.3% for UPRO/BSV rebalanced daily with no fees, and 14.8% for UPRO/BSV rebalanced whenever the effective leverage went below 0.9 or above 1.1 (with a $7 trading fee). Sharpe ratios were 0.058, 0.063, and 0.061, respectively. Of course, the greater your portfolio’s balance, the more your growth would look like the blue curve rather than the red one, since you can rebalance very frequently without trading costs hurting you very much. I know, an extra 1% isn’t that much. But just like a 1% expense ratio can really hurt you over time, a 1% boost every year can really make a big difference. If you go year by year you see that UPRO/BSV tends to tack on an extra 1-2% to SPY’s annual growth, although it doesn’t always. Annual growth of SPY and UPRO/BSV portfolios. Year SPY BSV UPRO/BSV (no fees) UPRO/BSV (fees) 2009 22.3% 2.1% 23.7% 23.4% 2010 13.1% 3.8% 15.5% 14.0% 2011 0.9% 3.0% 2.3% 2.2% 2012 14.2% 1.5% 14.9% 14.2% 2013 29.0% 0.2% 28.3% 28.1% 2014 14.6% 1.4% 14.9% 14.9% 2015 -7.1% 1.4% -6.6% -7.2% One-Third 3x Leveraged ETF, Two-Thirds VBISX We can only look at UPRO/BSV back to 2009, but it’s easy enough to switch UPRO for a hypothetical 3x SPY ETF, and switch BSV for the Vanguard Short-Term Bond Index Fund Investor Shares (MUTF: VBISX ), so we can go back further. For the 3x SPY ETF, we’ll assume no tracking error and a 0.95% annual expense ratio, mimicking UPRO. The correlation between daily gains for the simulated 3x SPY ETF and UPRO since UPRO’s inception is 0.997. The correlation between monthly gains for BSV and VBISX since BSV’s inception is 0.963. Let’s see how one-third 3x SPY, two-thirds VBISX would have performed since 1994. (click to enlarge) The top-off portfolios achieved nearly double the balance of SPY over the 20.5-year period. Sharpe ratios were 0.033 for SPY, 0.043 for 3x SPY/VBISX with no fees, and 0.043 for 3x SPY/VBISX with fees. Of course it is important to note that VBISX has done really well since 1994, with a CAGR of 4.4%. Note that the top-off portfolio with fees beat SPY in 21 out of 22 years (all except 1994), and on average beat SPY by 3.1%. You can see the consistent annual outperformance below. (click to enlarge) Another way to visualize the outperformance of the top-off portfolio relative to SPY: (click to enlarge) A Portfolio Optimization View I came to the one-third 3x SPY, two-thirds short-term bonds portfolio from the perspective of mimicking SPY by combining a 3x leveraged ETF with cash, but then putting the cash to work to gain an extra few percentage points. But you can also view the strategy from a portfolio optimization perspective. A short-term bond fund like BSV has positive alpha simply from the fact that it yields a certain small percentage annually from maturing bonds of various durations. So in periods when SPY is flat, BSV still tends to grow (i.e. it has positive alpha). Indeed if you regress monthly VBISX gains vs. monthly SPY gains going back to 1994, VBISX has alpha of 0.0036 (p < 0.001), meaning it gains on average 0.36% in months when SPY is flat. Typical Stocks/Bonds Story? It is well-known that holding both stocks and bonds tends to improve risk-adjusted returns. But if you hold an S&P 500 index fund in addition to bonds, your net beta drops below 1 and you often sacrifice raw returns. The UPRO/BSV approach is unique in that it keeps beta at 1 (assuming BSV has no correlation with SPY), while increasing both risk-adjusted and raw returns. Something like a free lunch. Upping the Ante A natural extension of the UPRO/BSV top-off strategy is combining UPRO with a longer duration bond fund. For example I like one-third UPRO, two-thirds BND, for a bigger top-off. But BND is much more variable than BSV, and also much more sensitive to rising interest rates. Another way to "up the ante" so to speak is to aim for some leverage greater than 1, say 1.25 or 1.5. You can still combine UPRO with BSV to get some extra growth at any leverage below 3, but the greater your net leverage, the greater your allocation to UPRO has to be, and the less you have left over to grow in BSV. Risks Many investors may not be comfortable with a portfolio that requires a significant allocation to a leveraged fund. Indeed, there are risks associated with leveraged funds. In particular: If SPY ever experiences an intraday loss of one-third its opening price, you could lose the entire balance in the leveraged ETF. While leveraged S&P 500 ETFs like UPRO have historically had very little tracking error, daily gains may occasionally deviate from the target multiple. In between rebalancing periods, you may suffer some irrecoverable losses due to volatility decay. It is important to note that while the top-off strategy uses leveraged ETFs, the target net leverage for the portfolio is 1. In that sense, the portfolio is not prone to the greatly amplified volatility (and potentially catastrophic drawdowns) usually associated with leveraged ETFs. It is very important to understand these issues before implementing the SPY top-off strategy. Indeed, many investors may decide that the potential for slightly higher annual returns does not justify the added risks. I personally believe that the risk/reward for the strategy is favorable. Conclusions A one-third UPRO, two-thirds BSV portfolio should behave very similarly to a 100% SPY portfolio, but often generate an extra 1-4% annual return. You'll have to monitor your effective leverage (multiply your UPRO allocation by 3) and rebalance when it deviates much from 1, but for a reasonably sized portfolio this should not detract much from your extra gains relative to SPY. Of course, you don't have to use UPRO and BSV. Other 3x S&P 500 ETFs and short-term bond funds should perform similarly. And if you want an extra boost, consider pairing the leveraged ETF with an intermediate or long-term bond fund, or a total bond fund. But your annual gains will be more variable, and you may suffer losses as interest rates rise. I am currently implementing the SPY top-off strategy with UPRO and BND, but may switch to UPRO and BSV in the near future for a more consistent, albeit smaller, bonus. Ideally, I'll beat SPY by a little bit every year, and eventually be happy.

Low Volatility Portfolio Optimization Works Where Momentum Strategies Fail

Summary Momentum strategies have worked exceedingly well since 2008. It takes some effort to find a diversified portfolio for which momentum strategies fail. Adaptive asset allocation based on portfolio optimization with high volatility target also fails when momentum strategies fail. Adaptive asset allocation based on portfolio optimization with low volatility target performs well even when momentum strategies fail. Momentum strategies are very popular and are readily available at no cost on the internet. In fact, it takes some effort to find a well diversified portfolio of equities and bonds that would have failed. I used the “dual momentum” and the “relative strength” timing models on the portfoliovisualizer.com site and run a sequence of simulation on some ETF portfolios that included stocks, bonds, real estate and commodities. The portfolio I selected for the study is made up of six ETFs and it performed poorly for the momentum strategy with any look back period. As a benchmark we analyze the performance of the portfolio with equal weight targets, rebalanced when the allocation of any asset deviates by more than 20% from the target weight. That portfolio was subjected to 21 rebalancings within the time interval of the study from January 2007 to September 2015. In this article I compare the momentum strategy with the adaptive allocation strategies I described in many previously published articles. We investigate two versions of the strategy: a return maximization with a low volatility target, and another with a high volatility target. The version with low volatility target was subjected to 105 reallocations of the assets, virtually almost every month. The version with high volatility target was subjected to only 52 reallocations because it was allocated, on average, about two months to the same asset. Here is the list of securities used to build the portfolio: SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) iShares U.S. Real Estate ETF (NYSEARCA: IYR ) SPDR Gold Trust ETF (NYSEARCA: GLD ) T he United States Oil ETF, LP (NYSEARCA: USO ) iShares 1-3 Year Treasury Bond ETF (NYSEARCA: SHY ) iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) The data for the study were downloaded from Yahoo Finance on the Historical Prices menu for SPY, IYR, GLD, USO, SHY and TLT. We use the daily price data adjusted for dividend payments. For the adaptive allocation strategy, the portfolio is managed as dictated by the mean-variance optimization algorithm developed on the Modern Portfolio Theory (Markowitz). The allocation is rebalanced monthly at market closing of the first trading day of the month. The optimization algorithm seeks to maximize the return under a constraint on the portfolio risk determined as the standard deviation of daily returns. In table 1 we list the total return, the compound average growth rate (CAGR%), the maximum drawdown (maxDD%), the annual volatility (VOL%), the Sharpe ratio and the Sortino ratio of the portfolios. Table 1. Performance of the portfolios from January 2007 to September 2015. TotRet% CAGR% maxDD% VOL% Sharpe Sortino Equal Weight 36.95 3.70 -35.85 10.46 0.32 0.42 AA LOW volatility 65.03 5.96 -11.05 6.02 0.99 1.32 AA HIGH volatility -4.73 -0.56 -55.18 23.19 -0.02 -0.03 The data in table 1 should be compared to the results of applying the dual momentum strategy as computed with the portfolio visualizer application. The dual momentum strategy investing monthly in the asset with the highest return over the previous 3 months had total return of -10.34%, with CAGR of -1.25%, maximum drawdown of -40.88% and volatility (St Dev) of 20.48%. There were two periods when the momentum strategy suffered huge losses; first in 2011-12 after gold topped, and the second in 2014-15 when oil prices tanked. The AA high volatility results are very similar to the dual momentum results. Most of the difference in drawdown and volatility is due to the fact that I use daily closing data while the portfolio visualizer site uses monthly data. That explains the slightly larger volatility and drawdown of the AA high volatility compared to the dual momentum. The small difference in the total return is due to a different allocation of the two strategies during a few months in 2011, as will be seen in figure 2. Of the three strategies, the AA with low volatility target performs the best both in return and risk. It produces a steady return of about 6% annually with a low volatility of only 6% and a maximum drawdown of -11%. The performance of the equal weight strategy falls in the middle; it returns on average almost 4% with low volatility of 10%, but still rather large drawdown of -36%. The equal weight strategy suffered steep losses during the 2008-09 bear market. In figures 1a and 1b we show the historical allocation of assets for the adaptive allocation strategy. (click to enlarge) Figure 1a. Historical asset allocation for the low volatility target portfolio. Source: All the charts in this article are based on calculations using the adjusted daily closing share prices of securities. As can be seen in figure 1a, the portfolio was allocated to SHY about 50% over the entire time. It was also allocated about 25% each to SPY and TLT. There were only small allocations to gold, oil and real estate. (click to enlarge) Figure 1b. Historical asset allocation for the high volatility target portfolio. Here one sees that the high volatility target portfolio was allocated alternately to one asset only, the same as in the momentum strategy. Only for a few months in 2009 was the portfolio invested in two assets simultaneously. In figure 2 we show the equity curves of the adaptive allocation portfolios. (click to enlarge) Figure 2. Equity curves for the adaptive allocation (NYSE: AA ) portfolios. We see in figure 2 that the high volatility target portfolio performed well until the fall of 2011. Since then, the equity either went down or oscillated in a range. Recently the equity fell below the initial investment. In figure 3 we show the equity curves of the low volatility and equal weight portfolio. (click to enlarge) Figure 3. Equity curves of the adaptive allocation with low volatility target and the equal weight portfolios. We see in figure 3 that the equal weight portfolio suffered large losses during the 2008-09 financial crises. It performed well between 2009 and 2012, but it fluctuates in a range since 2013. Still, overall, the equal weight portfolio performed better than the adaptive allocation or momentum strategy, as can be seen in figure 4. (click to enlarge) Figure 4. Equity curves of the adaptive allocation with high volatility target and the equal weight portfolios. Source: All the charts in this article are based on calculations using the adjusted daily closing share prices of securities. Conclusion The adaptive allocation by portfolio optimization with low volatility target performs satisfactorily during all market environments. Over a long investment horizon, it beats the equal weight as well as the momentum strategies.