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3 Ways To Play A Nearing Fed Rate Hike

Summary Thanks to weaker than expected job growth and retail sales along with global economic uncertainty, the futures market is not expecting a rate hike until into 2016. Investors want to plan for rising interest rates should look for investments with low duration, low interest rate sensitivity or that can profit from higher rates. In this article, I suggest three different ETFs that can fit those criteria. With the target Fed Funds rate sitting at 0% for the last 6+ years, the Fed is finally getting poised to raise interest rates again. Many watchers felt a rate hike in 2015 was imminent until a slew of economic data – weak job growth and retail sales data along with uncertainty in China – have pushed off rate hike expectations into 2016. Fed funds futures suggest that there’s only a 50-50 chance will see a rate hike at the March Fed meeting with the first likely hike coming in June. For those looking to protect themselves from rising rates, now might be a good time to reposition your portfolio. That means looking for investments that maintain a low duration, staying away from sectors that are highly rate sensitive and looking for stocks that can profit from higher rates. If you’re looking to stay away from interest rate risk, consider these ETFs for your portfolio. The iShares 1-3 Year Treasury Bond ETF (NYSEARCA: SHY ) This is the good old fashioned conservative approach. Its 30 yield of 0.49% won’t necessarily impress income seeking investors but with a beta of near zero this is exactly the type of risk averse investment that those looking for safety should consider. Since its inception in 2002, we’ve been able to see how the fund performs in both a rising rate and falling rate environment. In the 2004-2007 period when the Fed Funds rate rose from 1% to over 5%, the fund managed a total return of around 8%. Not a huge return by any means but it demonstrates how the fund was still able to generate a return even in a rapidly rising rate environment. In the subsequent 2007-2008 period during the financial crisis when the target Fed Funds rate dropped to 0%, the fund returned around 12%. These are solid returns in both scenarios but the risk minimization and capital preservation strategy of this ETF is what matters most. The SPDR S&P Bank ETF (NYSEARCA: KBE ) Banks profit when the yield curve is steeper and interest rates are higher. This fund debuted right at the tail end of when interest rates were rising in 2005. As you can see, the overall performance of the fund followed the Fed Funds rate downward. KBE Total Return Price data by YCharts Conversely, it would be expected that bank stocks should outperform when rates begin moving back up. Being an equity ETF, this will still experience the volatility that comes with investing in the stock market but it should be positioned better than the broader market when rates finally begin to move back up. The PowerShares S&P 500 ex-Rate Sensitive Low Volatility Portfolio (NYSEARCA: XRLV ) Debuting just earlier this year, this ETF looks to isolate the stocks of the S&P 500 that exhibit the lowest volatility and low interest rate sensitivity characteristics of the broader index. The fund’s composition is largely as one would expect. Most of the fund’s assets are invested in financials, industrials, consumer defensive and health care stocks – areas of the market that experience steady demand and are less prone to economic fluctuations. There’s not much of a track record to go on with this ETF but the strategy is such that it should help limit the downside associated with interest rate risk while maintaining broader exposure to the equity markets.

Simple ETF Portfolio Performance With Monthly Reallocation By Mean-Variance-Optimization

Summary The simple ETF portfolio with monthly reallocation performed better than the equal weight portfolio in 2015. The low and mid risk portfolios had good positive returns, while the high risk portfolio had a very small loss. Even the high risk portfolio performed better than the equal weight portfolio. The simple ETF portfolio was introduced in an article published in August 2015. Since then the markets suffered a mini crash and a correction associated with high volatility and very negative market sentiment. Investors all over the world moved large amount of money out of the stock market and into other “perceived safer” asset classes such as bonds. It is appropriate, therefore, to ask ourselves how an adaptive strategy is dealing with this kind of market environment. In this article we analyze the performance of the simple ETF portfolio, emphasizing its results during the latest period of high market turbulence. For completeness, we will review the historical performance of the portfolio since January 2003, but will discuss in more detail its performance during the first nine months of 2015. The portfolio is made up of the following four ETFs: SPDR S&P MidCap 400 ETF (NYSEARCA: MDY ) PowerShares QQQ Trust ETF (NASDAQ: QQQ ) iShares 1-3 Year Treasury Bond ETF (NYSEARCA: SHY ) iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) Basic information about the funds was extracted from Yahoo Finance and marketwatch.com and it is shown in table 1. Table 1. Symbol Inception Date Net Assets Yield% Category MDY 5/04/1995 14.23B 1.41% Mid-Cap Blend QQQ 3/03/1999 36.93B 0.96% Large Growth SHY 7/22/2002 13.11B 0.48% Short Term Treasury Bond TLT 7/22/2002 6.41B 2.62% Long Term Treasury Bond The data for the study were downloaded from Yahoo Finance on the Historical Prices menu for MDY, QQQ, 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. The portfolios are optimized for three levels of risk: LOW, MID and HIGH. The corresponding annual volatility targets are 5%, 10% and 15% respectively. In Table 2 we show the performance of the strategy applied monthly from January 2003 to September 2015. Table 2. Performance of MVO algorithm applied monthly versus an equal weight portfolio. TotRet% CAGR% VOL% maxDD% Sharpe Sortino 2015 return LOW risk 167.65 8.03 5.60 -5.59 1.43 1.99 3.16% MID risk 399.09 13.45 10.61 -10.34 1.27 1.68 3.60% HIGH risk 697.85 17.70 16.40 -17.18 1.08 1.52 -0.33% Equal weight 204.71 9.14 9.58 -24.50 0.95 1.29 -1.33% Please notice that the realized volatilities are well correlated with the target values. In fact, the realized volatilities are just slightly greater that the target values. Also, as expected, the realized annual returns are also well correlated to the volatility targets. All the values in the CAGR% column are a little greater than the realized volatilities in the VOL% column. The 2015 returns column shows that all MVO strategies performed better than the equal weight portfolio. The LOW and MID risk portfolios achieved a positive return of over 3% while the equal weight portfolio lost 1.33%. The HIGH risk portfolio lost a minute 0.33%. The equity curves for all portfolios are shown in Figure 1. (click to enlarge) Figure 1. Equity curves of the portfolios with MVO monthly optimization and equal weight allocation. Source: All charts in this article are based on calculations using the adjusted daily closing share prices of securities. We see in figure 1 that the equity of the LOW risk portfolio had a constant, very stable, rate of increase over the entire time of the simulation. It was almost unaffected by any market event. By contrast, the equity of the equal weight strategy with rebalancing shows the highest variability and the highest loss during the 2008-09 crises. The equal weight strategy worked quite well during long bullish periods of the market such as during 2003-07 and 2009-14. The MID and HIGH risk strategies worked extremely well during the 2009-14 period with a very brief periods of mild correction in 2011. All strategies show a flattening of their equity curves during 2015. In Figures 2, 3 and 4 we show the time allocation for all MVO strategies from January 2014 to September 2015. We decided to display the allocations over a shorter most recent time interval in order to get graphs that are easy to read. (click to enlarge) Figure 2. In figure 2 we see that the LOW risk strategy allocated, on average, over 60% of the money to the bond funds. About 30% to 40% was allocated alternately to QQQ or MDY. (click to enlarge) Figure 3. In figure 3 we see that in 2014 the money was allocated alternately between TLT and QQQ. The first half of 2015 the allocation went to MDY and TLT. In July and August of 2015 the money was allocated to QQQ and SHY, switching all to TLT and SHY in September and October. (click to enlarge) Figure 4. In figure 4 we see that the HIGH risk strategy allocates the money to a single asset at any time. Since January 2014 it simply alternated between QQQ and TLT. This strategy worked very well most of the time, but in the first nine months of 2015 it suffered a very small loss. In table 4 we show the current allocations for all the strategies. Table 3. Current allocations for October 2015. MDY QQQ SHY TLT LOW risk 0% 0% 69% 31% MID risk 0% 0% 35% 65% HIGH risk 0% 0% 0% 100% As seen in table 3 all portfolios are invested only in bond funds, regardless of risk level. The low risk portfolio in mostly invested in the short term, while the high risk is 100% in long term treasuries. Conclusion The simple ETF portfolio with monthly reallocation performed better than the equal weight portfolio in 2015.The low and mid risk portfolios had good positive returns, while the high risk portfolio had a very small loss. Additional disclosure: The article was written for educational purposes and should not be considered as specific investment advice.

Why BND Is The Only Bond Fund I Own

Summary Bonds provide diversification away from stocks. Yields on bonds beat out a bank account. Rising rates are an obvious risk, but how much risk is there really? Finding a fund that’s “not too hot, not too cold”. The Vanguard Total Bond Market ETF (NYSEARCA: BND ) is the only bond fund I own, and that’s probably how it will stay. “Why own bonds at all?” some investors might be asking. I’d like to clarify why I personally have a small allocation to them, despite being relatively young at 28 years old. Markets look expensive, even after a correction While I like the valuations of the individual equities I already own, I’ll also acknowledge that the market as a whole looks expensive relative to historical valuations. According to Multpl.com , the S&P 500 is currently trading at a tick under 19 times earnings versus a historical multiple of around 15-16 times earnings. The Shiller Cyclically Adjusted PE Ratio is at around 24 times earnings, versus a historical average of around 16-17 times earnings. I think that the collapsing earnings of oil-related companies (as well as strong currency-related headwinds) could be weighing down earnings, making the market look more expensive than it really is, but I don’t think it hurts to be cautious, either. The most obvious reason I own bonds, therefore, is for diversification. Simply put, in terms of corrections and even bear markets, bonds traditionally hold up better than equities: SPY data by YCharts The majority of my individual investment portfolio and retirement accounts will remain in equities, but I do maintain a small position in the BND fund. I plan to continue to dollar cost average into it going forward, and I think it’s a better idea than holding cash while waiting for bargains to appear if markets continue to correct. Yield starvation and the lack of savings I have a tough time saving cash in excess of an emergency account right now, largely because there really isn’t any place to put it where it won’t be eaten up by inflation over time. The best place I can currently find (and where I keep my savings at) is Synchrony Bank’s high yield savings account . It only pays 1.05% APY, however, and CDs aren’t much better. Plus, with a CD, my money is locked up for a couple of years at less-than-attractive rates. So opting out of a savings account for yield, there’s short-term treasuries (NYSEARCA: SHY ) as well. These usually don’t come close to the above-mentioned savings account in yield, however, so I don’t see a reason to favor them over cash. I could also consider buying longer dated treasuries (NYSEARCA: TLT ), but then there’s substantial rate risk, as the Federal Reserve still might raise rates this year or even next year. The Fed, rates, and the “bond bubble” While I’ve often heard that there’s a bubble in bonds, and that they’re very risky due to rates being at zero for six years, I think that this talk is somewhat superficial. I’m not so sure that being 100% in equities at this point in time is for me. Long-dated treasuries offer decent yield, but they’re also very sensitive to rates. Usually to get any kind of decent yield out of a bond fund, you’d have to buy a fund with a long duration with lots of risk if rates rise. The alternative is to buy a fund with low credit quality, which pushes up yields. Either way, it seems most bond funds are either risky credit-wise or risky rising rate-wise. Here’s where The Vanguard Total Bond Market ETF starts to make sense. It yields 2.21% with an average duration of just 5.7 years. So with a 1% increase in rates, the fund would lose approximately 5.7% of its value. That’s pretty good for a bond fund in my opinion, because if the Fed does raise rates, I highly doubt it will be more than 0.25% or 0.5%. Even if it does, the yield on this fund should increase along with the bump in rates, as higher yielding bonds are added to the index. Credit wise, the BND also stands out, with the majority of the bonds held within the fund being high grade: (click to enlarge) Source: Vanguard I think that this is one of the best bond funds out there right now, especially considering its expense ratio is just 0.07%. The duration is also reasonable enough to largely prevent dramatic price drops in principal if the Fed does raise rates by the end of the year. Conclusion The BND is a “not too hot, not too cold” holding in my opinion. It’s not likely going to give investors much capital appreciation, or enough yield to get them excited about it. I’m personally holding it, however, largely because I think it’s a better alternative to cash, and I think it will hold up better than equities if the market continues to head south. I can then liquidate some (or even all) of my stake to go shopping for bargains. If markets don’t continue to correct, I don’t see that much downside, and at least I’m getting paid some income along the way. I’ll continue to be overweight equities at this point, but I don’t think it hurts to maintain a small position in the BND as an insurance measure, either.