Tag Archives: portfolio

EMB Offers Investors An Interesting Play On Credit Risk With Mixed Durations

Summary The portfolio for EMB is heavy on bonds that are just barely investment grade. The maturity of those bonds is heavily diversified but the one empty part of the curve is short durations. A mixed duration on the bonds allows it to have a positive correlation with medium-term treasury ETFs. Despite the positive correlation with treasuries, it also has a positive correlation with the equity markets due to the credit risk exposure. The iShares J.P. Morgan USD Emerging Markets Bond ETF (NYSEARCA: EMB ) is a very interesting option for investors wanting to add some new exposures to their portfolio. There are plenty of reasons for investors to be worried, but it remains an interesting allocation for a small part of the portfolio. Expense Ratio The expense ratio on EMB is .40% which feels like it would be typical for finding exposure to a somewhat niche market like investing in the bonds of emerging markets. That would probably be a fair assessment as well. While Vanguard also runs a fund in this niche market, the Vanguard Emerging Markets Government Bond Index Fund ETF (NASDAQ: VWOB ), the expense ratio in that fund is .34%. While there is a difference in the expense ratios, the difference is not very substantial. While EMB does have a higher expense ratio, it also has more than ten times the average volume with around 1.3 million shares per day changing hands compared to a hundred thousand for VWOB. Since shares of EMB are more expensive, adjusting for the difference in price would only extend the liquidity advantage of EMB. Credit Ratings The credit ratings on bonds in the portfolio can be seen below The majority of the bonds can be considered investment grade since the heaviest position is in the BBB rated bonds. However, it should be clear that there is still a substantial weighting to investments with lower credit ratings and this portfolio should be seen as being a fairly aggressive debt investment and share prices could be hit from factors as simple as an increase in the credit spread between riskier bonds and treasury securities. Maturity The following chart shows the maturities: This portfolio is incredibly diversified in the maturity of the securities. However, since the diversification includes a very material allocation over 20 years and very little at the shortest end of the yield curve it would be wise for investors to keep in mind that they are facing both substantial credit risk and duration risk. That makes this an interesting ETF for investors trying to optimize their portfolio for low volatility. Building the Portfolio This hypothetical portfolio has a slightly aggressive allocation for the middle aged investor. Only 30% of the total portfolio value is placed in bonds and a third of that bond allocation is given to emerging market bonds. However, another 10% of the portfolio is given to preferred shares and 10% is given to a minimum volatility fund that has proven to be fairly stable. Within the bond portfolio, the portion of bonds that are not from emerging markets are high quality medium term treasury securities that show a negative correlation to most equity assets. The result is a portfolio that is substantially less volatile than what most investors would build for themselves. For a younger investor with a high risk tolerance this may be significantly more conservative than they would need. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. (click to enlarge) A quick rundown of the portfolio The two bond funds in the portfolio are for higher yielding debt from emerging markets and (NYSEARCA: IEF ) for medium term treasury debt. IEF should be useful for the highly negative correlation it provides relative to the equity positions. EMB on the other hand is attempting to produce more current income with less duration risk by taking on some risk from investing in emerging markets. The position in (NYSEARCA: USMV ) offers investors substantially lower volatility with a beta of only .7 which makes the fund an excellent fit for many investors. It won’t climb as fast as the rest of the market, but it also does better at resisting drawdowns. It may not be “exciting”, but there are plenty of other areas to find “excitement” in life. Wondering if your retirement account is going to implode should not be a source of excitement. The position in (NYSEARCA: PKW ) makes the portfolio overweight on companies that are performing buybacks. The strategy has produced surprisingly solid returns over the sample period. I wouldn’t normally consider this as a necessary exposure for investors, but it seemed like an interesting one to include and with a very high correlation to SPY and similar levels of volatility it has little impact on the numbers for the rest of the portfolio. The core of the portfolio comes from simple exposure to the S&P 500 via (NYSEARCA: SPY ), though I would suggest that investors creating a new portfolio and not tied into an ETF for that large domestic position should consider the alternative by Vanguard (NYSEARCA: VOO ) which offers similar holdings and a lower expense ratio. I have yet to see any good argument for not using or another very similar fund as the core of a portfolio. In this piece I’m using SPY because some investors with a very long history of selling SPY may not want to trigger the capital gains tax on selling the position and thus choose to continue holding SPY rather than the alternatives with lower expense ratios. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. To make it easier to analyze how risky each holding would be in the context of the portfolio, I have most of these holdings weighted at a simple 10%. Because of IEF’s heavy negative correlation, it receives a weighting of 20%. Since SPY is used as the core of the portfolio, it merits a weighting of 40%. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the S&P 500 . Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. Conclusion When EMB is measured simply on the annualized volatility it does very fairly well. However, the difficult part about having mixed duration emerging market debt is that the poor credit rating encourages the portfolio to have a positive correlation with the market. If an investor is trying to minimize volatility they may be using a position in medium or long term treasury ETFs which would create some overlap on the long duration exposure but at very different credit ratings. Simply put, EMB manages to have positive correlation with both the market and with the treasury securities that have a negative correlation with the market. I like this bond space, however due to the strange situation with the correlations I would lean toward using it as a small portion of the portfolio. In this example I used it at 10%, but I suspect that 5% might be a more reasonable way to allocate it into the portfolio. Overall, you could say I find more things to like than dislike, but I would still limit the size of the exposure. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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. 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.

SCHH: A Little Too Much SPG, But I’m Still Using It

Summary SCHH is a great REIT ETF with a very low expense ratio. The holdings are little too heavy on SPG and the retail REIT sector in general. When considered within a portfolio the diversification benefits of SCHH are less important when the portfolio already has a large bond holding. Investors should treat SCHH as an optional replacement for a combination of equity and bonds. If I could make a modification to the SCHH portfolio, it would be to decrease retail REITs and increase residential REITs in lower income markets with higher capitalization rates. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. I’m working on building a new portfolio and I’m going to be analyzing several of the ETFs that I am considering for my personal portfolio. One of the funds that I’m considering is the Schwab U.S. REIT ETF (NYSEARCA: SCHH ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. Expense Ratio SCHH has an expense ratio of .07%. The expense ratio is great for equity REIT ETF options. This is one of the holdings I’ve been adding to whenever I saw it dip. Largest Holdings I love what a REIT index does for diversifying a portfolio. However, when I look at the internal holdings of the ETF, I wish there was a little more diversification. Namely, I would like to see a cap on exposure to any individual REIT at about 5% to 6% of holdings. The holdings are shown below: (click to enlarge) Nothing against Simon Property Group, Inc. (NYSE: SPG ), I just don’t want to see 10% of my index fund invested in a single company. Types of REITs (click to enlarge) When we look at the type of REIT holdings by sector, I get the feeling that I would prefer to see retail REITs with a lower weights and residential REITs with a higher weight. I suppose that comes back to my issue with having over 10% of the portfolio in SPG. Drop that down and put the capital into a heavier weight on residential REITs and I’d be very happy with the overall portfolio composition. Building the Portfolio I put together a hypothetical portfolio using only ETFs that fall under the “free to trade” category for Charles Schwab accounts. My bias towards these ETFs is simple, I have my solo 401k there and recently moved my IRA accounts there as well. When I’m building a list of ETFs to consider I want to focus on things I can trade freely so that I can keep making small transactions to buy more when the market falls. Within the hypothetical portfolio there are no expense ratios higher than .18%. Just like trading costs, I want to be frugal with expense ratios. The portfolio is fairly aggressive. Only 30% of the total is allocated to bonds and I would consider that the weakest area in the portfolio. I’d like to see more bond options (with very low expense ratios) show up on the “One Source” list for free trading. (click to enlarge) A quick rundown of the portfolio The Schwab U.S. Dividend Equity ETF (NYSEARCA: SCHD ) is a dividend index. The Schwab U.S. Broad Market ETF (NYSEARCA: SCHB ) is a broad market index. The Schwab U.S. Large-Cap ETF (NYSEARCA: SCHX ) is focused on blended large cap exposure. The Schwab International Equity ETF (NYSEARCA: SCHF ) is developed international equity. The Schwab Emerging Markets ETF (NYSEARCA: SCHE ) is emerging market equity. The Schwab International Small-Cap Equity ETF (NYSEARCA: SCHC ) is developed small capitalization equity. is domestic equity REITs. The Schwab U.S. Aggregate Bond ETF (NYSEARCA: SCHZ ) is a remarkably complete bond fund. The SPDR Barclays Long Term Treasury ETF (NYSEARCA: TLO ) is a long term treasury ETF. The PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSEARCA: ZROZ ) is an extremely long term treasury ETF. Notice that the 3 international equity ETFs have only been weighted at 5% while the broad market index has been weighted at 25%. I find heavy exposure to international equity to bring more risk than expected returns so I try to keep my international exposure low. I prefer no more than 20% in international equity. Plenty of domestic companies already have enormous international operations so the benefit of international diversification is not as strong as it would be if the markets were isolated from each other. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. When TLO and ZROZ post negative risk contribution it is because the negative correlation to most of the equity holdings results in the long term treasury ETFs reducing the total portfolio risk. In my opinion, this is the best argument for including them in the portfolio. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. (click to enlarge) The Role of SCHH REIT ETFs can perform a couple roles within a portfolio. One major use of REITs is to boost the income yield from the portfolio, but SCHH doesn’t pay out as high of a dividend yield as some of the other equity REIT index funds. In my book, that makes it more useful for investors that are not concerned about distributions for decades. Since I’m holding the ETF in a tax advantaged account, I won’t have to worry about capital gains taxes either. Since SCHH is not offering a high current yield for investors, it is useful to look at the diversification benefits because SCHH runs between .70 and .60 on correlation with all of the other equity ETFs in the portfolio. The only real weakness for holding a large allocation in equity REITs is the correlation with bonds is not as favorable as it is for the other equity ETFs. If an investor wants to completely avoid using bond exposure in their portfolio, as I’ve been doing, then equity REIT indexes are absolutely critical in reducing the risk level. When the portfolio is including a substantial allocation to bonds it will reduce the optimal allocation for equity REITs. Conclusion SCHH may not offer a high dividend yield, but for long term investors looking to build an optimal portfolio it makes sense as a solid index fund with a very low expense ratio. When investors increase their allocation to equity REIT indexes it may be appropriate to fund the portfolio by selling both domestic equity and bond ETFs. If the investor sells out of their position in REITs, the most intelligent allocation strategy would be to split the proceeds between bonds and equity. With the domestic equity REIT space, SCHH is a very attractive ETF for having a very low expense ratio. The biggest thing I would like to see changed is moving some the retail REIT exposure to residential REIT exposure. If I were to get even more specific, I would love to see the residential REIT exposure focused on markets with higher capitalization rates and lower value properties that would be expected to do better in a recession. If I were adding individual equity REITs to my portfolio to compliment SCHH, I’d start with looking for ones that operated low income properties. Disclosure: I am/we are long SCHB, SCHD, SCHF, SCHH. (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.

PIMCO Total Return: 1 Bill Gross-Less Year Later

Summary The PIMCO Total Return Fund assets under management have shrunk from $293B in early 2013 to less than $100B today. The new managers of the fund were part of the investment committee working with Bill Gross during his tenure so management style should remain consistent. The fund, at least in the year-to-date period without Gross managing, has outperformed its benchmark and Morningstar category. The managers are currently retaining a cautious approach to the portfolio in anticipation of future rate hikes. In the relatively mundane world of mutual fund investing there was perhaps no news bigger than last year’s surprising announcement that Bill Gross was leaving PIMCO – the company he founded – to jump over to Janus. The move resulted in a mass exodus from Gross’ Total Return Fund (MUTF: PTTRX ). Once the largest mutual fund in the world back in 2013 with $293B in assets now has less than $100B. Many investors felt that Gross was the key that drove the engine and fled for greener pastures when he departed (although his current fund – the Janus Global Unconstrained Bond Fund (MUTF: JUCDX ) – has just $1.5B in assets). For investors that have stuck around it’s worth wondering if the “new” PIMCO Total Return fund is the same now as it was when Gross was in charge. Gross himself has said in the past that investors maintain at least a five year outlook when formulating their portfolios. However, Gross has been known to quickly change directions. This is perhaps most notable in his 2011 call on interest rates. Gross thought that interest rates would rise once QE was done and took his portfolio’s allocation in Treasury bonds all the way down to zero. Of course, interest rates went down, the fund badly underperformed its benchmarks and the flow of money out of the fund began. The new fund managers for their part have pledged largely to maintain the groupthink investment style that was part of the decision making process even when Gross was involved. Style-wise, the fund still falls into Morningstar’s intermediate term bond category where it’s been for the last many years. There are a couple of important things to note in the figure above. First, performance on a one year basis can’t really be used as a long term predictor of success but at least the new managers are off to a reasonable start. Year-to-date, the fund is beating its benchmark index by 27 basis points and the broader intermediate term bond fund category by 64 basis points. That puts Total Return in the top 15% of funds – a notable departure from recent performance that saw the fund fall into the bottom half three of the last four years. Second, turnover and trading frequency remain at comparable levels to the end of Gross’ tenure. The fund is running at a turnover rate of about 265% which is fairly comparable to the past two years’ rate of 227%. Going forward, the fund’s managers are limiting duration in the United States anticipating coming rate hikes maintaining roughly ⅔ of the portfolio in government and mortgage-backed securities. Smaller allocations to corporates, high yields and even some emerging markets adds return potential and yield to the portfolio. Consistent with its more defensive outlook, the current portfolio duration is around 4 years – much lower than the benchmark’s 5.6. Conclusion It’s understandable that investors would begin looking elsewhere following Gross’ departure. But shareholders who have stuck around have done just fine in the meantime. I think we’ve seen in the first year post-Gross that the fund is managed in a substantially similar way. The consistency of the portfolio management team that worked behind Gross is still largely intact. Gross’ decades of expertise may no longer be around but Total Return is still in able and, at least thus far, in solidly performing hands. Despite the wave of outflows that is still occurring yet today there’s no reason why the current PIMCO Total Return fund shouldn’t at least be considered for the income part of a portfolio. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.