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A Lower-Risk Way To Invest In The Dow

Summary During the average 6-month period over the last 10 years, the Dow-tracking ETF DIA gained 3.98%. DIA shareholders suffered a 38% decline during one of those 6-month periods. A hedged portfolio of Dow component stocks, such as the one shown below, can offer a higher expected return with less than half the drawdown risk. Although cost is a concern when hedging, in our example, the hedged portfolio has a negative cost. Risk Versus Return For The Dow-Tracking ETF Although not as widely-traded as ETFs tracking the S&P 500 and the Nasdaq, according to the ETF Database , the SPDR Dow Jones Industrial Average ETF (NYSEARCA: DIA ) is among the top-40 ETFs by average trading volume over the last 3 months, and has assets under management of over $11.5 billion, so it holds a place in the portfolios of a lot of investors. Any of those investors who owned DIA in late 2008 and early 2009 saw the ETF drop about 38% within a six-month period between August of 2008 and February of 2009. During the average six-month period over the last ten years, though, DIA investors had a respectable total return of about 3.98%. But as we’ll show below, by using the hedged portfolio method to invest in some of DIA’s top holdings, an investor can get a higher expected return over the next six months while risking a drawdown less than half as large as the one mentioned above. When Stocks Can Be Safer Than An ETF It may seem counterintuitive that you can be exposed to less risk by holding a handful of Dow components than by holding the ETF that owns all of them, but that can be the case when you own those stocks within a hedged portfolio. Although a diversified limits the idiosyncratic risk of owning individual stocks, it doesn’t limit market risk (DIA isn’t as diversified as some ETFs, as it has about half of its assets in its top-10 holdings). But a hedged portfolio limits both. Below, we’ll show how to construct a hedged portfolio out of DIA top holdings for an investor who is unwilling to risk a drawdown of more than 19%, and has $500,000 that he wants to invest. First, though, let’s address the issue of risk tolerance, and how it affects potential return. Risk Tolerance and Potential Return All else equal, with a hedged portfolio, the greater an investor’s risk tolerance — the greater the maximum drawdown he is willing to risk (his “threshold”, in our terminology) – the higher his potential return will be. So, we should expect that an investor who is willing to risk a 29% decline will have a chance at higher potential returns than one who is only willing to risk a 9% drawdown. In our example, we’ll be splitting the difference and using a 19% threshold (half of the 38% drawdown DIA investors experienced in 2008-2009). Constructing A Hedged Portfolio We’ll recap the hedged portfolio method here briefly, and then explain how you can implement it yourself using DIA’s top holdings as a starting point. Finally, we’ll present an example of a hedged portfolio that was constructed this way with an automated tool. The process, in broad strokes, is this: Find securities with relatively high potential returns. Find securities that are relatively inexpensive to hedge. Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high potential returns net of their hedging costs (or, ones with high net potential returns). Hedge them. The potential benefits of this approach are two-fold: If you are successful at the first step (finding securities with high expected returns), and you hold a concentrated portfolio of them, your portfolio should generate decent returns over time. If you are hedged, and your return estimates are completely wrong, on occasion — or the market moves against you — your downside will be strictly limited. How to Implement This Approach Finding Promising Stocks If we were looking for securities with the highest potential returns, we wouldn’t limit ourselves to just Dow components; instead, we’d consider a much broader universe of stocks. But since we’re concerned with Dow stocks here, we’ll start with the top holdings of DIA. To quantify potential returns for DIA’s top holdings, you can check Seeking Alpha Pro for articles that offer price targets for the stocks, or you can use sell-side analysts’ consensus price targets for them and then convert those to percentage returns from current prices. For example, via Nasdaq , this is the 12 month consensus price target for Dow component and top-10 DIA holding Goldman Sachs (NYSE: GS ): You can use that consensus price target as a starting point for your estimate, adjusting it based on the time frame you’re using and whether you think it is overly optimistic or not. In general, though, you’ll need to use the same time frame for each of your potential return calculations to facilitate comparisons of potential returns, hedging costs, and net expected returns. Our method starts with calculations of six-month expected returns. Finding inexpensive ways to hedge these securities Our method attempts to find optimal static hedges using collars as well as protective puts going out approximately six months. Whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-19% decline over the time frame covered by your potential return calculations. And you’ll need to calculate your cost of hedging as a percentage of position value. Select the securities with highest net potential returns When starting from a large universe of securities, you’d want to select the ones with the highest potential returns, net of hedging costs; you can do the same here, starting with the top holdings in DIA, but, in any case, you’ll at least want to exclude any of them that has a negative potential return net of hedging costs. It doesn’t make sense to pay X to hedge a stock if you estimate the stock will return

EVV And EVG: 2 More Eaton Vance Funds That Sound Alike, But Aren’t

Eaton Vance Limited Duration Income Fund sports a nearly 9.5% yield. Eaton Vance Short Duration Diversified Income Fund’s yield is around 8%. The risks involved favor the lower yield. Financial markets are in a state of flux right now. With the Federal Reserve continuing to keep interest rates at low levels, some might argue that there’s no need to worry. However, the Fed is keeping rates low because of weak global growth — certainly not a good thing. And how long can rates stay this low before unintended consequences start to rear their ugly heads? If you are the least bit concerned about the markets and interest rates Eaton Vance Limited Duration Income Fund (NYSEMKT: EVV ) and Eaton Vance Short Duration Diversified Income Fund (NYSE: EVG ) both sound like good places to hide in a storm. But that’s worth a closer look… Birds of a feather? EVV and EVG both share a similar mandate, providing investors with a high-level of current income. Capital appreciation is a secondary consideration for each. In addition, both closed-end funds, or CEFs, try to provide broad exposure to the fixed income markets while limiting interest rate risk. EVV’s duration is targeted to be between two and five years, while EVG is a little more conservative in that its duration is expected to be no more than three years. Although that’s a difference, it’s not exactly a huge one. At the end of the second quarter, EVV’s duration was around 3.2 years and EVG’s was around 2.1 years. Both funds, meanwhile, make use of leverage, something that can increase gains in good times but exacerbates losses in bad times. EVV and EVG even share five of six managers (EVV has six people steering the boat, EVG only five). One big difference between the pair is size. EVV has more than six times the assets of EVG, which helps explain why there’s an extra hand at the wheel. But this isn’t the only difference you’ll want to be aware of. The big obvious one for most investors will be the distribution yield. EVV’s yield is around 9.4%, roughly 17% higher than EVG’s 8%. That said, the yields are based on NAV at both funds, which are trading at over 10% discounts and are more reasonable, with EVV’s NAV yield at around 8.1% and EVG’s NAV yield of just about 7%. Based on this quick look, you might just go for the higher yield from the larger fund. But don’t jump just yet. A quick look at the engine Although duration is very important in the bond world, since it gives you an idea of the impact that interest rate changes will have on your return, it isn’t the only factor to watch for. (The longer the duration, the more impact interest rate changes will have.) Another important one is credit quality. While short durations can help to limit the risk of lower quality debt, since it will get paid off relatively quickly, it doesn’t remove the risk. And with investor concern high, low-quality debt has been taking a big hit. Perhaps rightly so. And that’s an important comparison point at EVV and EVG. At the end of the second quarter, EVV’s portfolio was made up of about 30% investment grade debt. So 70% of what it owns could be characterized as high-yield or “junk.” To be fair, BB, the highest-quality high-yield debt, makes up about 30% of that, but it still has heavy exposure to risky borrowers. EVG, on the other hand, had about half of its portfolio in investment grade issuers. There was another 25% or so in BB issuers. Of the two, EVG’s exposure to credit risk is much less than its sibling’s. That helps account for the lower yield, too, since higher-quality bonds tend to pay less interest than lower-quality fare. For investors concerned about a coming market storm, then, EVG appears to the less risky option. True, it has a lower yield, but that might be a worthwhile trade-off if you were looking at EVV and EVG to find a “safe” short-duration CEF bond fund to hide in. That said, there are some other factors to consider, too. For example, EVG’s portfolio is about two-thirds U.S. debt. EVV’s U.S. exposure is higher at around 85%. You could look at this difference in one of two ways. On the one hand, more diversification is better. On the other, sticking close to home may prove to be a more astute choice if the U.S. turns out to be the cleanest dirty shirt if, in my opinion when, the markets hit more turbulence. Then there’s the issue of long-term performance. Over the trailing 10 years through September, EVV’s annualized NAV return, which includes reinvested distributions, was about 6.4%. EVG’s annualized return over that span was about 5%. But that was then, and this is now. For example, over the trailing six months through September, EVG’s NAV loss was around 1.7% and EVV’s loss was nearly 3%. In September alone, EVV lost nearly 2% of its net asset value. EVG fell about 0.5% in September. So it looks like EVG has the edge when risk starts to matter, but EVV’s risk taking has paid off over the longer term. That, of course, is the big trade-off in investing: Risk vs. reward. Right now, I’d err on the side of caution and give EVG the edge if you are watching this pair. That said, if you buy EVG, you might want to keep an eye on EVV for a time when the skies are a little more clear.

Best And Worst Q4’15: Energy ETFs, Mutual Funds And Key Holdings

Summary The Energy sector ranks last in Q4’15. Based on an aggregation of ratings of 21 ETFs and 59 mutual funds. OIH is our top-rated Energy ETF and FSESX is our top-rated Energy mutual fund. The Energy sector ranks last out of the 10 sectors as detailed in our Q4’15 Sector Ratings for ETFs and Mutual Funds report. The Energy sector funds won last place in the prior quarter as well. It gets our Dangerous rating, which is based on aggregation of ratings of 21 ETFs and 59 mutual funds in the Energy sector. See a recap of our Q3’15 Sector Ratings here . Figures 1 and 2 show the five best and worst-rated ETFs and mutual funds in the sector. Not all Energy sector ETFs and mutual funds are created the same. The number of holdings varies widely (from 25 to 150). This variation creates drastically different investment implications and, therefore, ratings. Investors seeking exposure to the Energy sector should buy one of the Attractive-or-better rated ETFs or mutual funds from Figures 1 and 2. Figure 1: ETFs with the Best & Worst Ratings – Top 5 (click to enlarge) * Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings The PowerShares Dynamic Oil Services ETF (NYSEARCA: PXJ ) is excluded from Figure 1 because its total net assets are below $100 million and do not meet our liquidity minimums. Figure 2: Mutual Funds with the Best & Worst Ratings – Top 5 (click to enlarge) * Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity. Sources: New Constructs, LLC and company filings The Van Eck Market Vectors Oil Services ETF (NYSEARCA: OIH ) is the top-rated Energy ETF and the Fidelity Select Energy Service Portfolio (MUTF: FSESX ) is the top-rated Energy mutual fund. OIH earns an Attractive rating while FSESX earns a Neutral rating. The PowerShares DWA Energy Momentum Portfolio ETF (NYSEARCA: PXI ) is the worst-rated Energy ETF and the BP Capital TwinLine Energy Fund (MUTF: BPEAX ) is the worst-rated Energy mutual fund. Both earn a Very Dangerous rating. National Oilwell Varco (NYSE: NOV ) is one of our favorite stocks held by Energy ETFs and mutual funds. It earns our Attractive rating. Over the past four years, National Oilwell has grown after-tax profits ( NOPAT ) by 11% compounded annually. The company earns a return on invested capital ( ROIC ) of 8% and has generated over $1.1 billion in free cash flow on a trailing twelve-month basis. Across the energy industry, share prices have been collapsing over the past year, but National Oilwell’s business does not deserve the decline in its shares. At its current price of $38/share, NOV has a price to economic book value ( PEBV ) ratio of 0.6. This ratio implies that the market expects National Oilwell’s profits to permanently decline by 40% from current levels. If National Oilwell can grow NOPAT by just 1% compounded annually over the next five years , the stock is worth $80/share today – a 110% upside. It’s easy to see just how low the expectations baked into NOV have become. Tesoro Corporation (NYSE: TSO ) is one of our least favorite stocks held by Energy ETFs and mutual funds and earns our Very Dangerous rating. Since 2011, Tesoro’s NOPAT has declined by 1% compounded annually despite the oil industry witnessing high growth rates prior to 2014. Over the same timeframe, Tesoro’s ROIC has fallen to 6% from 12%. Despite the deterioration of the business, TSO has increased nearly 400% since 2011, which has left shares greatly overvalued. To justify its current price of $102/share, Tesoro must grow NOPAT by 10% compounded annually for the next 11 years. This scenario seems rather unlikely given that NOPAT has only declined lately. With such lofty expectations embedded in the stock price, it’s easy to see why Tesoro is one of our least favorite Energy stocks. Figures 3 and 4 show the rating landscape of all Energy ETFs and mutual funds. Figure 3: Separating the Best ETFs From the Worst ETFs (click to enlarge) Sources: New Constructs, LLC and company filings Figure 4: Separating the Best Mutual Funds From the Worst Mutual Funds (click to enlarge) Sources: New Constructs, LLC and company filings D isclosure: David Trainer and Thaxston McKee receive no compensation to write about any specific stock, sector or theme.