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No Imminent Lift Off? Time For These Dividend ETFs

Dividend investing has seen a lukewarm year so far in the U.S. as the markets speculated a faster-than-expected Fed lift-off prompted by steady growth in the domestic economy. As a result, most dividend ETFs are trading in red in the year-to-date frame. However, a volatile start to Q4 has once again put the spotlight on income-focused investing. Moreover, a still-patient Fed and the likelihood of more cheap money inflows cheered up dividend investing all over again. Be it bonds, high dividend equities, or pass-through securities, picks that target higher yielding securities have fared well since the dovish September Fed meet. The allure rose further after the U.S. economy reported sub-par job data for the month of September last week. The soft jobs’ report has raised questions over the health of the U.S. economy and the fate of Fed’s policy tightening. Headline job gains for September came in at 142K versus the estimated 200K and the prior month’s tally of 136K (read: ETFs that Gained & Lost Post Dismal Job Data ). The originally reported July tally was also revised lower to 223K from 245K originally. The year-to-date monthly pace of job gains now averages 198K, though the pace for the last three months was way lower at 167K. This goes against the monthly average of 260K for 2014. While a subdued inflation data and global growth worries were already obstacles on the course of the Fed policy, the job data made the case worse and Fed’s policy tightening seems some way off. Investors who were earlier overconfident about a December rate hike in the U.S., have now started to push back the timeline to early next year, presuming a sluggish U.S. economic rebound. While it is a decent setting for capital gains, Treasury bond yields slumped and are at 2.07% at the time of writing, leading some to believe that a new bull market may be at hand. In this type of an environment, investors can count on income picks for Q4. While individual stock pick is always an option, ETFs give options to fairly diversify one’s portfolio. 4 Dividend ETF Picks for Q4 SPDR S&P International Dividend ETF (NYSEARCA: DWX ) If you want to stay global, DWX could be your ticket as this fund focuses only on high yielding stocks from around the globe. After all, most developed economies are supposed to carry on their accommodative stance next year unlike the U.S. This is done by tracking the S&P International Dividend Opportunities Index, a benchmark that holds about 100 securities in its basket. Currently, the $1 billion-fund is a bit heavy on traditional high yield sectors like financials (24.8%), utilities (22.8%), telecom (15.9%), and energy (14.2%), though no single company accounts for more than 3.4% of the total assets. In terms of yields, this pays a solid 5.91%, while it charges investors a reasonable 45 basis points a year in fees for the service. The fund was up over 6.9% in the last five days (as of October 5, 2015). Vanguard High Dividend Yield ETF (NYSEARCA: VYM ) This large cap centric fund provides exposure to the high yielding U.S. dividend stocks by tracking the FTSE High Dividend Yield Index and could thus be a lucrative option for those seeking higher current income. The ETF is one of the largest and popular choices in the dividend ETF space with AUM of over $10.3 billion. Expense ratio comes in at 10 bps (read: 3 Excellent Dividend ETFs for Growth and Income ). In terms of sector, the fund is widely spread out with financials, consumer goods, technology, industrials, health care, and oil & gas taking double-digit exposure in the basket. The fund yields 3.33% as of October 5 and was up over 5.6% in the last five trading sessions. The ETF has a Zacks ETF Rank #3 (Hold) with a Medium risk outlook (read: 3 Cheap Value ETFs with Strong Dividend ). Schwab U.S. Dividend Equity ETF (NYSEARCA: SCHD ) This fund tracks the Dow Jones U.S. Dividend 100 Index, which measures the performance of high dividend yielding U.S. stocks that have a record of consistently paying dividends. Notably, companies, that raise dividends regularly, appear steadier than those which offer higher yields. In a market crash, these dividend aristocrats stand out pretty strong and navigate through volatility. The product has already amassed roughly $2.51 billion in assets and has a dividend yield of 3.15%. The fund charges a meager 7 bps in fees and trades in solid volume of more than 500,000 shares per day. Consumer Staples is the fund’s focus sector with about one-fourth exposure followed by IT (19.74%) and Industrials (13.85%). It currently has a Zacks Rank #3 and added about 5.3% in the last five trading sessions (as of October 5, 2015). SPDR Dividend ETF (NYSEARCA: SDY ) This fund provides exposure to the 102 U.S. stocks that have been consistently increasing their dividend every year for at least 25 years. It follows the S&P High Yield Dividend Aristocrats Index and has amassed $12 billion in AUM. Volume is solid, exchanging more than 765,000 shares in hand, while expense ratio comes in at 0.35%. The product is widely diversified across components as each security accounts for less than 2.81% of total assets. Financials is the top sector taking up one-fourth of the portfolio while consumer staples (15.1%), industrials (13.4%) and utilities (11.8%) round off the next three spots. The fund was up nearly 5% in the last five days and has a Zacks ETF Rank of 3. Link to the original post on Zacks.com

3 ETFs Covering The Defense Industry

Summary PPA offers the broadest, most diverse portfolio, extending its coverage to cybersecurity and communications, but at a cost. ITA offers the highest dividend yield, but also seems to lack the performance edge of the other funds. XAR has a small portfolio, and has the fewest assets of the three, but may have performance advantages. Given current world tensions, there is no wonder one of the major concerns in Washington, D.C. (particularly Republican legislators) is national defense; in particular, there is a great desire to increase military spending, with both parties seeking ways to add more funds to the defense budget, differing only on how much and how to account for it. 1 It seems like a good time to review one’s holdings in the area of defense, and it also seems that a good way to cast a wide net over this industry segment is with an ETF. There are currently three that focus on aerospace and defense (A&D): PowerShares Aerospace & Defense Portfolio ETF (NYSEARCA: PPA ) iShares U.S. Aerospace & Defense ETF (NYSEARCA: ITA ) SPDR S&P Aerospace & Defense ETF (NYSEARCA: XAR ) Comparison These funds are offered by three of the major ETF sources, and they show it. The smaller of the three – XAR – weighs in at more than $100 million in assets; it is also the youngest of the three (relatively speaking), having its inception in 2011. Blackrock (NYSE: BLK ) gives its iShares offering, ITA , typical heft with a $458 million in assets under management. PPA brings a NAV of nearly $230 million. XAR also has the lowest expense ratio (0.35%) of the three, with ITA next lowest (0.45%) and PPA coming in with a just-above-average ER of 0.66%. 2 In more practical terms, ITA has an expense margin (EM) of 74.83%, compared to XAR’s EM of 72.50% and PPA’s 58.78% EM. 3 The three funds overlap on 27 companies – something one would expect given the tight focus of the associated indices. Moreover, eight of those companies show up in the top-ten holdings of each of the funds: The Boeing Company (NYSE: BA ) Rockwell Collins Inc. (NYSE: COL ) General Dynamics Corporation (NYSE: GD ) Lockheed Martin Corporation (NYSE: LMT ) Northrop Grumman Corporation (NYSE: NOC ) Precision Castparts Corp. (NYSE: PCP ) Raytheon Company (NYSE: RTN ) United Technologies Corporation (NYSE: UTX ) Of the three funds, ITA and XAR are the most similar. Both are guided by similar indexes – that is, to the extent that the S&P index used by XAR and the Dow Jones index employed by ITA can be said to be “similar.” ITA has the larger portfolio – both in terms of number of holdings and assets – but in addition to the 27 companies they have in common with each other and with PPA , ITA and XAR overlap on an additional five holdings. In this respect, the two funds are almost identical. All three funds make their selections based on market cap , with ITA and XAR also introducing liquidity considerations. The funds are rebalanced quarterly. By way of contrasts, PPA and XAR each has an aspect with respect to which it differs from the others in the group. PPA defines A&D in broader terms than the other two funds, allowing it to define a larger universe of prospective holdings and resulting in a significantly larger number of holdings than either ITA and XAR . The broader concept of A&D adds companies in communications and cybersecurity to the mix; the portfolio is therefore more diverse and less focused than that of the fund’s competitors. While both PPA and ITA are cap-weighted funds, XAR is equal weighted. As I have written elsewhere, I do have a preference for equal-weighted funds; 4 research indicates that, over the long haul, such funds tend to outperform cap-weighted funds – indeed, they tend to be among the best-performing funds. The boost is due to the fact that equal-weighted funds put more emphasis on mid – and small – capped companies , which are more likely to see significant growths in share value than large-capped firms. At the same time, however, the greater exposure to small-capped holdings – in particular – adds an increased element of volatility . Performance All of the funds have enjoyed fairly consistent growth since their inceptions, as illustrated here: (click to enlarge) Of course, ITA and PPA both had to contend with the recession from 2007 – 2009, and ITA seems to have been particularly hard hit. All three funds have managed to more than double their share values. A direct comparison of performance on the basis of price is not easy, given the differences in share prices, but the following chart looks at the funds’ performance: (click to enlarge) All three funds seem to be following the same general trend, and it seems doubtful that PPA ‘s broader focus has made any significant improvement in performance (although it does perform somewhat better than the other two funds). For a more direct comparison of the three funds the following chart compares their performance since the inception of XAR : (click to enlarge) What I find interesting here is that both ITA and PPA are very close in performance, with PPA having a roughly 320bps edge over ITA (due to the larger number of holdings?). But note that XAR significantly outperforms the competition; it currently has a 1335bps lead over PPA , and that is down from its position at the beginning of 2015. 5 Since XAR has the smallest portfolio of the group, it is not size that counts; furthermore, the three funds overlap on a significant part of their holdings – particularly between XAR and ITA – making it less likely that the particular holdings of the funds is the cause of the difference in performance. I am drawn to the conclusion that XAR’s weighting scheme is the important factor in its performance. The following chart illustrates the funds’ performance year-to-date: (click to enlarge) What is interesting to note here is that while XAR was outperforming the other two funds for most of the year (so far), after the dramatic drops realized over the past summer XAR is actually performing at a lower level than the other two funds. This gives us a rather dramatic illustration of the downside to equal weighting. Assessment I am increasingly becoming a big fan of equal weighting. All things considered, I find XAR to be the best of these three funds. It has a trim portfolio – especially compared to PPA’s 53 holdings – and its equally weighted portfolio seems to have a marked edge over the more standard, cap-weighted portfolios offered by PPA and ITA . Someone wanting to cast a broader net over the defense industry might prefer the more open focus of PPA . That broader focus does come at a price, as PPA offers the lowest dividend yield of the three. This may be due to the fact that cybersecurity firms often do not pay dividends, but the just-under-$230-million NAV and seven million shares outstanding certainly don’t help here. I do not think that the difference in dividends between PPA and ITA outweighs the performance edge PPA seems to have, however. PPA does have a very high ER , and does seem to be more lightly traded than either ITA or XAR . For its part, ITA offers the typical BlackRock advantage: size . It is by far the largest ETF in terms of AUM. Its cap-weighted scheme, along with the assets it has to back that up, pretty much assure shareholders of regular dividends . The fact that it has only roughly 4.5 million shares outstanding (compared to PPA’s seven million) means the distributions are not going to be overly diluted. Disclaimers This article is for informational use only. It is not intended as a recommendation or inducement to purchase or sell any financial instrument issued by or pertaining to any company or fund mentioned or described herein. All data contained herein is accurate to the best of my ability to ascertain, and is drawn from the Company’s Prospectus, Statement of Additional Information, and fact sheets. All tables, charts and graphs are produced by me using data acquired from pertinent documents; historical price data from Yahoo! Finance . Data from any other sources (if used) is cited as such. All opinions contained herein are mine unless otherwise indicated. The opinions of others that may be included are identified as such and do not necessarily reflect my own views. Before investing, readers are reminded that they are responsible for performing their own due diligence; they are also reminded that it is possible to lose part or all of their invested money. Please invest carefully. 1 On October 1, for instance, House Republicans approved a $612 billion defense authorization bill (” House passes sweeping defense policy bill ,” Reuters, October 1, 2015), a bill President Obama has promised to veto. The President seeks a more modest increase in spending, suggesting a base budget of $534 billion, with an additional $51 billion in “war funds” (” Defense chief says Obama likely to veto defense policy bill ,” Reuters, September 30, 2015). 2 Expenses have been averaging around 0.62%. ” ETF Fees Creep Higher ,” Rick Ferri, Forbes.com . According to Ferri, figures indicated that since the 1990s, ERs have been gradually increasing. 3 For those unfamiliar with my use of “expense margin,” this is what I consider to be the ETF’s equivalent of “operating margin”: it is the cost of the ETF’s doing business. To determine the EM divide the actual net income realized by the ETF by the ETF’s gross income. One could replace net income with total distributions to shareholders. Essentially, the idea is to determine how much of an ETF’s income is passed on to shareholders. I discuss the issue in detail in my article ” Ignore ETF Expense Ratios? Maybe. ” As a practical application, consider that while XAR has a lower ER than ITA, it actually distributes smaller proportion of its gross income than ITA does. Since XAR’s expenses are lower, one would suspect that it does not realize as much income (proportionately) as ITA. 4 ” Guggenheim s RSP: Equal Weight Or Dead Weight? ” 5 At XAR’s high point for this year (10 April), it was up 153% since inception; PPA was up 148.96% since its inception; ITA was up 141.27% from its starting point. More impressively, starting all three funds from XAR’s inception date through 10 April 2015, XAR was up 153.30%, PPA was up 124.49% and ITA was up 125.48%.

CEF Portfolio Generates 9% Income With Reasonable Risk

Summary The CEF portfolio had an average distribution of 9.4% coupled with lower risk than the S&P 500. The CEF portfolio is diversified among many types of funds including bonds, preferred stocks, equities, and covered calls. Most of the selected CEFs are selling at historically large discounts. As an income focused investor, I’m a fan of Closed End Funds (CEFs), and have written many articles on Seeking Alpha discussing their risks and rewards. Many CEFs have recently taken it on the chin because of fear that the Fed may begin raising rates. To my mind, this has created CEF bargains among many asset classes. This article constructs a diversified portfolio of CEFs that are selling at large discounts and also have reasonable risk-versus-reward profiles. Below is a summary of the CEFs I have selected. I apologize in advance if I did not include your favorite CEF and I welcome alternative suggestions from readers. The data is based on the 2 October market close. BlackRock Corporate High Yield Fund (NYSE: HYT ). This is one of the largest high yield CEFs with a market cap of $1.3 billion. Over the past 5 years, this CEF has sold for a both discounts and premiums. Premiums were relatively rare and reached a high of 6% in 2012. The fund typically sells at a discount, averaging about 5% over the past 5 years but increasing to a 12% average during the past year. The current discount is 15.2%. The portfolio is a combination of high yield bonds (87%) and equities (7%). The fund utilizes 31% leverage and has an expense ratio of 1.3%. The distribution is 8.7%, funded by income with a small amount of Return of Capital (ROC). The ROC is typically only about 1% of the total distribution. Brookfield Total Return Fund (NYSE: HTR ). This fund focuses on mortgage backed securities (MBS). Over the past 5 years this CEF has sold primarily at a discount. The 5 year average discount was 5% but the discount has grown to a 9% average over the past year. The current discount is 16.5%. The portfolio consists mostly of MBS and asset backed securities with the majority coming from the commercial and residential non-agency sectors. About 40% of the bonds are investment grade. The fund utilizes 28% leverage and has an expense ratio of 1.3%. The distribution is 10.9%, funded by income with no ROC. Nuveen Credit Strategic Income Fund (NYSE: JQC ). JQC has a market cap of about $1.1 billion and is the largest CEF focused on floating rate loans. Over the past 5 years, this CEF has sold mostly at a discount. The only time this fund sold at a premium was a short period in 2013. The five year average discount is 8% and the one year average is 12%. The current discount is 15.2%. The portfolio consists of a combination of floating rate loans (68%) and corporate bonds (19%). Less than 10% of the holdings are investment grade. The fund utilizes 38% leverage and has an expense ratio of 1.8%. The distribution is 7.6%, funded by income with no ROC. AGIC Convertible and Income Fund II (NYSE: NCV ). This fund focuses on convertible securities. Over the past 5 years, this CEF has sold mostly at a premium, sometimes as high as 15%. It was not until the second half of 2015 that the fund, began selling at a discount. The five year average was a premium of 7% and the 1 year average was a premium of 5%. The current discount is 14.4%. The portfolio consists of a combination of convertible bonds (58%) and high yield bonds (41%). Less than 10% of the holdings are investment grade. The fund utilizes 33% leverage and has an expense ratio of 1.2%. The distribution was recently reduced but is still 13.3%. The distribution is funded by income with no ROC. Nuveen Preferred Income Opportunities Fund (NYSE: JPC ). This fund focused on preferred shares. Over the past 5 years this CEF has sold only for a discount. The smallest discount was about 1% in 2012. The 5 year average discount is 9% and the 1 year average discount increased to over 10%. The current discount is 11%. The portfolio consists primarily of preferred stock (88%) with a small amount of equities (6%). The fund utilizes 29% leverage and has an expense ratio of 1.7%. The distribution is 9%, funded by income with no ROC. Cohen Steers Quality Income Realty Fund (NYSE: RQI ). This fund is focused on REITs. Over the past 5 years this CEF has sold only at a discount. The discount has oscillated between less than 1% to over 14%. The 5 year average has been a discount of 8% but the 1 year average has increased to a discount of 12%. The current discount is 12.5%. The portfolio consists of a combination of REITs (80%) and preferred stock (19%). The fund utilizes 25% leverage and has an expense ratio of 1.9%. The distribution is 8.6%, funded by income with no ROC. Eaton Vance Enhanced Equity Income Fund II (NYSE: EOS ). This is a covered call fund. Over the past 5 years this CEF has sold for a both a discount and a premium, but mostly at a discount. The premium was as high as 5% in 2010. The premium turned into a discount in 2011 and has stayed at a discount ever since. The discount sunk to 15% in 2011 but has been improving in recent years. The 5 year average has been a discount of about 8% and the 1 year average is only 5%. The current discount is 8.5%. The portfolio consists equities that are used for call writing on about 50% of the portfolio. The fund managers have a flexible mandate and can invest in all size companies but most are medium to large cap. The fund does not use leverage and has an expense ratio of 1.1%. The distribution is 8.4%. The fund has a small amount of ROC but this is not unusual for covered call funds. Cohen & Steers Infrastructure Fund (NYSE: UTF ). This fund focuses on utilities. Over the past 5 years this CEF has always sold at a discount. The discount has grown larger in 2015. The 5 year average has been a discount of about 11% and the 1 year average is 13%. The current discount is 16.8%. The portfolio consists of investments in utility and infrastructure companies. The portfolio contains 80% equities, 10% bonds, and 5% preferred shares. About 60% of the holdings are domiciled in the US. The fund utilizes 29% leverage and has an expense ratio of 2%. The distribution is 8.5% funded by income and capital gains with no ROC. The characteristics of an equally weighted portfolio of these CEFs are summarized in Figure 1. The portfolio has an average distribution of 9.4%, which definitely achieves the objective of high income. The average discount is also large at 14%. (click to enlarge) Figure 1: Portfolio averages Even more important than the value of the discount is how it relates to the average discounts over the past year. This is measured by a metric called the Z-score, which is a statistic popularized by Morningstar to measure how far a discount (or premium) is from the mean discount (or premium). The Z-score is computed in terms of standard deviations from the mean so it can be used to rank CEFs. A good source for Z-scores is the CEFAnalyzer website. A Z-score more negative than minus 2 is relatively rare, occurring less than 2.25% of the time. With the exception of JPC and RQI, the selected CEFs are selling at historically large discounts as evidenced by the large negative Z-score. Both JPC and RQI have large discounts but the discounts are close to the average discount for the year. Figure 2 shows the allocation among asset classes as: bonds (50%), preferred stocks (16%), and equities (33%). Most of the equity portion is hedged by using covered calls. Thus, overall this is a defensive portfolio, which I believe is prudent given the current uncertainties in the market. (click to enlarge) Figure 2: Allocations among asset classes The portfolio looks promising in terms of income but total return and risk are also important so I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility for each of the component funds. The risk free rate was set at 0% so that performance could be easily assessed. I equated volatility with risk and used a 5 year look-back period from October 2, 2010 to October 2, 2015. The plot is shown in Figure 3. (click to enlarge) Figure 3. Risk versus reward for past 5 years. In the figure, the risk-versus-reward for each CEF is represented by a green diamond. The performance of the composite portfolio is shown by the blue dot. I also included the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) ETF as a comparison with the overall market. As is evident from the figure, the CEFs had a wide range of returns and volatilities. Were the returns commensurate with the increased risk? To answer this question, I calculated the Sharpe Ratio. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 3, I plotted a red line that represents the Sharpe Ratio associated with the composite portfolio. If an asset is above the line, it has a higher Sharpe Ratio than composite portfolio. Conversely, if an asset is below the line, the reward-to-risk is worse than the portfolio. You may be surprised that the volatility of the portfolio is smaller than the volatilities of the components. This is an illustration of an amazing discovery made by an economist named Markowitz in 1950. He found that if you combined certain types of risky assets, you could construct a portfolio that had less risk than the components. His work was so revolutionary that he was awarded the Nobel Prize. The key to constructing such a portfolio was to select components that were not highly correlated with one another. In other words, the more diversified the portfolio, the more potential volatility reduction you can receive. To be “diversified,” you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the funds. The data is presented in Figure 4. All the CEFs had relatively low correlations with SPY and each other. The only large correlation is the covered call CEF with the S&P 500. This is not surprising since large and medium cap companies were used for writing covered calls. Overall, these results were consistent with a well-diversified portfolio and hence, the reduction in portfolio volatility. (click to enlarge) Figure 4. Correlations over the past 5 years. Some interesting observations are apparent from Figure 3. SPY generated a higher return than the portfolio but SPY also had a higher volatility. SPY and the portfolio had virtually the same risk-adjusted performance. Thus, I believe that the composite portfolio is a good tradeoff for the risk averse investor looking for income. To get additional views of the how the portfolio performed, I analyzed two other metrics. The first is graphed in Figure 5 and shows the growth of wealth over the 5 years period. The plot assumes that the portfolio is frequently rebalanced to maintain equal weighting. As illustrated by the graph, wealth grew at a steady pace over the 5 year period. (click to enlarge) Figure 5 Growth of wealth for CEF portfolio The value of the portfolio decreased a few times along the way. The second metric is plotted in Figure 6 and provides a measure of the draw downs that an investor would experience. The figure illustrates that you can expect periods of relatively large draw downs, which could reach as high as 14% in a few cases. Thus, the portfolio is best suited for long term investors who can weather moderate draw downs. Note that we are currently in a 10% drawdown period, which is similar to draw downs in the past. (click to enlarge) Figure 6. Draw downs associated with the CEF portfolio Bottom Line Many of the CEFs in this portfolio have recently taken price hits, which have resulted in large discounts. No one knows what the future may hold but if the future is anywhere close to the past, these CEFs will recover and the discounts will revert back to the mean. If this turns out to be true, you can receive high income while you wait. Overall I believe this portfolio provides high income with reasonable risk.