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FFTWX: Want To Retire In 2025? Build A More Efficient Portfolio

Summary FFTWX offers investors a high expense ratio to go with a needlessly complex portfolio. By incorporating an enormous volume of other mutual funds the target date fund incorporates a higher expense ratio. If the fund needs exposure to the total U.S. market, they can ditch the complicated combination of funds and just use FSTVX. Lately I have been doing some research on target date retirement funds. Despite the concept of a target date retirement fund being fairly simple, the investment options appear to vary quite dramatically in quality. Some of the funds have dramatically more complex holdings consisting with a high volume of various funds while others use only a few funds and yet achieve excellent diversification. My goal is help investors recognize which funds are the most useful tools for planning for retirement. In this article I’m focusing on the Fidelity Freedom® 2025 Fund (MUTF: FFTWX ). What do funds like FFTWX do? They establish a portfolio based on a hypothetical start to retirement period. The portfolios are generally going to be designed under Modern Portfolio Theory so the goal is to maximize the expected return relative to the amount of risk the portfolio takes on. As investors are approaching retirement it is assumed that their risk tolerance will be decreasing and thus the holdings of the fund should become more conservative over time. That won’t be the case for every investor, but it is a reasonable starting place for creating a retirement option when each investor cannot be surveyed about their own unique risk tolerances. Therefore, the holdings of FFTWX should be more aggressive now than they would be 3 years from now, but at all points we would expect the fund to be more conservative than a fund designed for investors that are expected to retire 5 years later. What Must Investors Know? The most important things to know about the funds are the expenses and either the individual holdings or the volatility of the portfolio as a whole. Regardless of the planned retirement date, high expense ratios are a problem. Depending on the individual, they may wish to modify their portfolio to be more or less aggressive than the holdings of FFTWX. Expense Ratio The expense ratio of Fidelity Freedom® 2025 is .70%. That expense ratio is simply too high. Investors using a target date fund need to keep an eye on those expenses. It is possible to create a very efficient portfolio using only a few funds. Ideally the funds selected for building the portfolio would be selected for offering excellent diversified exposure at very low expense ratios. At the most simplistic level, an investor is looking for domestic equity, international equity, domestic bonds, and international bonds. If any of those had to be left out, the international bond allocation is the least important. In my opinion, there is no need to use both growth and value indexes. There is no need to individually use large, medium, and small-cap allocations. For instance, the Fidelity Spartan® Total Market Index Fund (MUTF: FSTVX ) has a net expense ratio of .05% and offers exposure to the vast majority of the U.S. market. If you were building a target date fund from Fidelity funds, you could simply use FSTVX and eliminate all other domestic equity funds. This method would provide investors with a low expense ratio on the underlying domestic equity position and excellent diversification. That is precisely why I am including FSTVX as a holding in my portfolio. The Vanguard Target Retirement 2025 fund has an expense ratio of .17%. Just so investors have a healthy comparison of how much it costs to run a very efficient target retirement fund, the Vanguard expense ratio gives a pretty clear indication. Holdings / Composition The following chart demonstrates the holdings of Fidelity Freedom® 2025: If you were making a target date fund, how many allocations would you need? Hopefully it wouldn’t be that many. Note that the holdings chart above simply showed the equity funds. There is another long list of funds for bond exposures. There is simply no need for a portfolio to be this complex. Volatility An investor may choose to use FFTWX in an employer sponsored account (if their employer has it on the approved list) while creating their own portfolio in separate accounts. Since I can’t predict what investors will choose to combine with the fund, I analyze it as being an entire portfolio. (click to enlarge) When we look at the volatility on FFTWX, it is dramatically lower than the volatility on the SPDR S&P 500 Trust ETF ( SPY). That shouldn’t be surprising since the portfolio has some large bond positions. Over the last five years it has significantly underperformed SPY, but that should be expected given the much lower beta and volatility of the fund. Investors should expect this fund to retain dramatically more value in a bear market and to fall behind in a prolonged bull market. Even adjusted for the beta, the returns on this portfolio were pretty weak. They were slightly over half the rate achieved by SPY. For comparison, one way an investor can achieve precisely half of the returns on SPY with precisely half the volatility is to buy SPY with half of their portfolio and leave the rest sitting in the account. That would have resulted in slightly lower returns, but it would also have resulted in a dramatically reduced max drawdown. For a fund designed for people that are retiring only a decade from now, having had a max drawdown that was almost as large as if the entire portfolio had been invested in SPY is a pretty poor performance. Opinions The first change I would want to make here is to see a lower expense ratio and a dramatically simplified portfolio of holdings. There is no need for a large complicated portfolio. To drive annualized volatility down while using Fidelity funds, I would favor using the Spartan ® Long-Term Treasury Bond Index Fund (MUTF: FLBAX ). The fund has a very high weighted average maturity (around 25 years), over 99% of the portfolio is in treasury securities (low credit risk), and an expense ratio of only .1%. That is a good solid mutual fund and using it in a target date portfolio fund with regular rebalancing allows investors to automatically take advantage of the negative correlation that long term treasuries have with the domestic equity market. Comparison Portfolio I used Invest Spy to put together a portfolio from Fidelity funds that I believe is dramatically superior to FFTWX. That portfolio is demonstrated below: (click to enlarge) This portfolio simply combines their total domestic market index (expense ratio .05%) with their long term treasury ETF (expense ratio .1%). The resulting expense ratio of the two underlying funds at a 50/50 weighting should be about .075%. This hypothetical portfolio had a max drawdown of only 7.3% and an annualized volatility of 7.2%, which is dramatically lower than the 10.4% reported for FFTWX. Of course, investors should not rely on historical results as predicting future results. The example is simply to demonstrate that a portfolio of domestic equities and long term treasuries has been capable of maintaining fairly low portfolio volatility due to the historical negative correlation of the two asset classes. Conclusion When an investor takes on an expense ratio that is even .3% higher and pays that ratio for 20 years, they are looking at losing 6% of the value of the portfolio without accounting for compounding. If investors account for the benefits of compounding and assume annual returns are positive, the potential value lost is even greater than 6%. FFTWX is an expensive option for investors looking for a simple “set it and forget it” retirement plan from their employer sponsored retirement accounts. The volatility of the fund is not a problem and the total exposures are not unreasonable. The problem comes down to two issues. One is that the fund has needlessly complicated the portfolio holdings and the other is that the expense ratio is simply too high when compared to similar products offered by competitors. There are some great funds offered by Fidelity and I have positions in a few of them. Unfortunately, this fund just falls short of the mark.

Consumer Staples Momo ETF Is A Winning Smart Beta Selection In A Defensive Sector

Investors looking for an ETF that is both defensive and has the potential for out performance should review PowerShares DWA Consumer Staples Momentum ETF. FINRA recently chimed in on Smart Beta ETFs with a Caveat Emptor opinion. As long as the US Dollar remains strong, this ETF should continue to excel. As with many previous market downturns, money has been flowing into the “safer” sectors of utilities, consumer staples, and telecom. If one looks at the recent high of the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) at $213.50 on May 21, the markets have fallen -9.3% as of Sept 23. Popular ETFs for these sectors are the Utilities Select Sector SPDR ETF (NYSEARCA: XLU ), the Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ) and the SPDR S&P Telecom ETF (NYSEARCA: XTL ). Since May 21, utility and consumer staples investors have been rewarded with better relative declines of -5.9% and -4.9%, respectively, while telecom lost about market average of -9.8%. However, if one looked at the declines of these sector ETFs from their most recent highs, the carnage is a bit worse. Utilities peaked on Jan 29 and has declined -15.1%, telecom peaked on June 18 and has fallen -11.9%. Consumer staples peaked on Aug 5 and has declined -7.2%. On a year to date base, SPY is down -2.9%, XLU -8.5%, XTL -3.3%, and XLP -1.2%. Within these popular defensive sectors, consumer staples would seem to be the best performer for relative performance against a backdrop of an overall market decline. There are 13 consumer staples ETFs listed on ETFdb.com . YTD performance ranges from 9.39% for the PowerShares DWA Consumer Staples Momentum Portfolio ETF (NYSEARCA: PSL ) to -46.1% for the Global X Brazil Consumer ETF (NYSEARCA: BRAQ ). The top three YTD US performers were: PSL, the PowerShares Dynamic Food & Beverage Portfolio ETF (NYSEARCA: PBJ ) at 5.3% and the Guggenheim S&P Equal Weight Consumer Staples ETF (NYSEARCA: RHS ) at 2.5%. On a 1-yr, 3-yr and 5-yr basis, PSL has outperformed both the SPY and XLP, with the majority of its relative strength clocking in since Oct 2014. Prior, PSL mirrored SPY and bested XLP and the recent outperformance has lifted overall returns. According to etfdb.com, during the past year, PSL has returned 18.5% vs 7.5% for XLP, on a 3-yr basis, PSL has returned 70.5% vs 41.9% for XLP, and on a 5-yr basis, PSL has returned 123.7% vs 93.9% for XLP. A 3-yr graph of PSL vs SPY and XLP is below. What is the investment strategy of PSL that creates the outperformance? As a “smart beta” ETF, the underlying portfolio shifts quarterly centered on individual stock’s technical performance relative to the sector. PSL is a PowerShares ETF offered by Invesco. From their website : “The PowerShares DWA Consumer Staples Momentum Portfolio ((Fund)) is based on the Dorsey Wright® Consumer Staples Technical Leaders Index (DWA Consumer Staples Technical Leaders Index). The Fund will normally invest at least 90% of its total assets in common stocks that comprise the Index. The Index is designed to identify companies that are showing relative strength (momentum), and is composed of at least 30 common stocks from the NASDAQ US Benchmark Index. The Fund and the Index are rebalanced and reconstituted quarterly.” Zack’s comments on PSL: “Consumer staples sector is on the rise as it is directly linked with improving economic fundamentals, in particular the spending power, which has increased owing to cheap fuel and rising income. As such, PSL has been able to withstand global worries, gaining 2.6% so far in the second half. The ETF provides exposure to 32 stocks having positive relative strength (momentum) characteristics by tracking the DWA Consumer Staples Technical Leaders Index. It has amassed $203.4 million in AUM and trades in lower volume of 56,000 shares a day on average. Expense ratio came in at 0.60%. The product is pretty spread out across securities, with each holding less than 4.9% of assets. It has a definite tilt toward mid cap stocks while the other two market cap levels take the remainder. Food products, beverages and household durables are the key industries in the ETF having double-digit exposure each.” Momentum investing, aka “momo”, is a strategy of buying stocks that have generated high returns over the past three to twelve months, and selling those that have experienced poor returns over the same period. The ETF seeks investment results that correspond to the price and yield of the DWA Consumer Staples Technical Leaders Index, which evaluates companies based on a variety of investment criteria, including fundamental growth, stock valuation, investment timeliness and risk, comparative to others in the sector. From DWA website concerning their relative strength and top-down approach: “Relative Strength: Relative Strength, the measurement of how one security performs in comparison to another, is a key concept within Dorsey Wright’s methodology. Before investing in UPS, one should understand its recent performance relative to FedEx, or the S&P 500. The same logic can be applied to sector analysis, asset class evaluation, mutual funds, ETFs, commodities, fixed income, and even foreign countries. A relative strength matrix is like a massive tournament, where a huge quantity of investment options can be compared to one another – and we see who is strongest. Relative strength is the basis for virtually all of our managed products, where we select the best investment options from within a large universe of options. Top-Down Approach: We use primary market indicators to get a measure of overall risk, and then analyze broad industry sectors to determine which are in favor. We want to invest in sectors that are controlled by demand. We then select investments that have positive relative strength and have a good probability of outperforming the market. We do not feel compelled to be fully invested in stocks when an alternative investment (cash reserves) offers a more attractive opportunity. In fact, it is our belief that avoiding severe losses is extremely important in achieving strong market performance over the course of an entire market cycle.” PSL is one of 14 momentum driven ETFs utilizing various Dorsey Wright Technical Leaders Indexes and a list of other Indexes is found here . DWA offers an in-depth White Paper on the Dorsey Wright Strategy titled ” Relative Strength and Portfolio Management ” pdf. PSL was rebalanced on June 30 and the most recent list of stocks is below: (click to enlarge) Due to its focus on owning the top momentum stocks with quarterly rebalancing, investors should not be surprised at a high 83% Annual Turnover Rate. According to Morningstar, of the companies listed above, one was purchased in 2012, three in 2013, nineteen in 2014 and nine in 2015. The ETF’s industry allocation is broad based within the consumer staples sector and is reported by Invesco as follow: As the strategy includes NASDAQ stocks, PSL’s portfolio will have higher exposure to mid-caps and small-caps than its large cap S&P ETF brethren. Not only are smaller companies known for higher earnings potential, but usually are focused on domestic US markets rather than an extensive international network. Recently, the strength of the US Dollar has weighted on revenue growth and exchange rates for large cap companies, and this concern is usually less with smaller companies. The strength in domestic markets and reduced currency risk exposure may be a factor in these specific company’s current individual outperformance. The outperformance of PSL compared to XLP coincides with the meteorically rise in the US Dollar starting in Aug 2014. The average market cap in the portfolio is $14.5 billion and 72% of the portfolio are mid-caps or smaller. Below is a table offered by Morningstar of PSL valuation and growth matrix compared to the Benchmark of S&P 1500 Consumer Staples and the Category of Morningstar Defensive. While the comparison indicates PSL is trading at a higher valuation than the Benchmark and Category, its growth profile is also quite a bit higher. With Cash-Flow Growth 25% above the benchmark and Book-Value Growth more than double the Benchmark, a higher valuation would seem appropriate. This week, FINRA issued an Investor Alert titled, “Smart Beta-What You Need to Know”. The bottom line of the alert is the old adage: Know what you are buying and what the strategy is of the specific ETF. There are about 840 products that fall into a smart beta category, representing almost half of all the exchange-traded products listed in the U.S. and investors should understand that any strategy that aims to beat the market carries its own risks. “Recently, there has been significant growth in the number of financial products, primarily ETFs, which are linked to and seek to track the performance of alternatively weighted indices. These indices are commonly referred to as “smart beta” indices. They are constructed using methodologies that rely on, for example, equal weighting of underlying component stocks, or measures such as volatility or earnings, rather than market-cap weighting. Investors need to understand there is no free lunch here. Any time you are deviating from the market, you’re taking some kind of tilt. Understand what is the fund doing that is different than the market. That is a risk.” Investors looking for an ETF that is both defensive and has the potential for outperformance should review PSL to evaluate how it may fit into their current portfolio construction. As long as the US dollar stays strong and the international economies remain in question, this ETF should continue to reward long term investors. However, FINRA is correct: Caveat Emptor. Author’s Note 1: NASDAQ OXM (NASDAQ: NDAQ ) agreed to acquire privately-held Dorsey Wright Associates in Jan for $225 million. This will push NASDAQ into the smart beta ETF market in an aggressive manner. Author’s Note 2: Please review disclosure in Author’s profile.

Want Some New Geography In Your Portfolio? ECON Is Fairly Unique

Summary ECON is heavily focused on consumer goods and services across the emerging markets. The holdings are unfortunately heavily concentrated into single companies. The companies come from a very diverse group of countries that offer investors exposure that they would struggle to replicate. The high expense ratio creates a problem from long term returns but investors could use the fund with tolerance bands to ensure buying low and selling high. One of the funds I’m examining is the EGShares Emerging Markets Consumer ETF (NYSEARCA: ECON ). 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 The expense ratio is a massive .83%. That is just incredibly heavy, but we should keep looking through the fund to see what is unique about the ETF. Industry (click to enlarge) The sector exposure is fairly simple. I’d rather see a further break down within the Consumer Goods and Consumer Services to establish “Staples” relative to “Discretionary” firms. I would be more interested in using an international ETF that focused on consumer staples than consumer discretionary companies. Largest Holdings (click to enlarge) The largest holding is over 10% of the portfolio and the rest of the top 10 are all greater than 3.5%. Investors may start to wonder where the expense ratio is going because it shouldn’t be going to trading expenses when the portfolio is so complicated. Geography (click to enlarge) This is easily the best part of the portfolio in my opinion. With the exception of China you aren’t likely to find many ETFs that are going to overweight the rest of these countries. The nice thing about this selection is that it creates excellent diversification. The one drawback to using diversification this way is that correlations increase dramatically during periods of crisis so the actual benefits to the portfolio value during a major correction won’t be as substantial as it should be. The other concern here is that I don’t like seeing China as a major weighting here. I’ve been a bear on China since summer. Their market moved up dramatically earlier in the year and has been correcting fairly hard. I’d rather avoid that source of risk in the current environment, but a few months can dramatically move prices and result in a very different assessment. Aside from my concerns about the Chinese economy, I would give this ETF a very solid 10 of 10 on incorporating countries that are often very low weights in an investor portfolio. Keep in mind that these emerging markets should be a fairly small weight in the investor portfolio, so a heavy allocation to ECON would be extremely dangerous. This kind of geographic diversification should be limited to no more than 5% to 10% of the portfolio, but I would want investors to be very aware of the risks before they went towards that 10% allocation. Building the Portfolio The sample portfolio I ran for this assessment is one that came out feeling a bit awkward. I’ve had some requests to include biotechnology ETFs and I decided it would be wise to also include a the related field of health care for a comparison. Since I wanted to create quite a bit of diversification, I put in 9 ETFs plus the S&P 500. The resulting portfolio is one that I think turned out to be too risky for most investors and certainly too risky for older investors. Despite that weakness, I opted to go with highlighting these ETFs in this manner because I think it is useful to show investors what it looks like when the allocations result in a suboptimal allocation. The weightings for each ETF in the portfolio are a simple 10% which results in 20% of the portfolio going to the combined Health Care and Biotechnology sectors. Outside of that we have one spot each for REITs, high yield bonds, TIPS, emerging market consumer staples, domestic consumer staples, foreign large capitalization firms, and long term bonds. The first thing I want to point out about these allocations are that for any older investor, running only 30% in bonds with 10% of that being high yield bonds is putting yourself in a fairly dangerous position. I will be highlighting the individual ETFs, but I would not endorse this portfolio as a whole. 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. Because a substantial portion of the yield from this portfolio comes from REITs and interest, I would favor this portfolio as a tax exempt strategy even if the investor was frequently rebalancing by adding new capital. The portfolio allocations can be seen below along with the dividend yields from each investment. Name Ticker Portfolio Weight Yield SPDR S&P 500 Trust ETF SPY 10.00% 2.11% Health Care Select Sect SPDR ETF XLV 10.00% 1.40% SPDR Biotech ETF XBI 10.00% 1.54% iShares U.S. Real Estate ETF IYR 10.00% 3.83% PowerShares Fundamental High Yield Corporate Bond Portfolio ETF PHB 10.00% 4.51% FlexShares iBoxx 3-Year Target Duration TIPS Index ETF TDTT 10.00% 0.16% EGShares Emerging Markets Consumer ETF ECON 10.00% 1.34% Fidelity MSCI Consumer Staples Index ETF FSTA 10.00% 2.99% iShares MSCI EAFE ETF EFA 10.00% 2.89% Vanguard Long-Term Bond ETF BLV 10.00% 4.02% Portfolio 100.00% 2.48% The next chart shows the annualized volatility and beta of the portfolio since October of 2013. (click to enlarge) Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. You can see immediately since this is a simple “equal weight” portfolio that XBI is by far the most risky ETF from the perspective of what it does to the portfolio’s volatility. You can also see that BLV has a negative total risk impact on the portfolio. When you see negative risk contributions in this kind of assessment it generally means that there will be significantly negative correlations with other asset classes in the portfolio. The position in TDTT is also unique for having a risk contribution of almost nothing. Unfortunately, it also provides a weak yield and weak return with little opportunity for that to change unless yields on TIPS improve substantially. If that happened, it would create a significant loss before the position would start generating meaningful levels of income. A quick rundown of the portfolio I put together the following chart that really simplifies the role of each investment: Name Ticker Role in Portfolio SPDR S&P 500 Trust ETF SPY Core of Portfolio Health Care Select Sect SPDR ETF XLV Hedge Risk of Higher Costs SPDR Biotech ETF XBI Increase Expected Return iShares U.S. Real Estate ETF IYR Diversify Domestic Risk PowerShares Fundamental High Yield Corporate Bond Portfolio ETF PHB Strong Yields on Bond Investments FlexShares iBoxx 3-Year Target Duration TIPS Index ETF TDTT Very Low Volatility EGShares Emerging Markets Consumer ETF ECON Enhance Foreign Exposure Fidelity MSCI Consumer Staples Index ETF FSTA Reduce Portfolio Risk iShares MSCI EAFE ETF EFA Enhance Foreign Exposure Vanguard Long-Term Bond ETF BLV Negative Correlation, Strong Yield Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio. 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) Conclusion ECON has some very interesting geographical concentrations. While the regression shows a fairly high correlation with the S&P 500, the ETF has had a very weak return over the last 5 years which is precisely the opposite of what I would say about the S&P 500. When comparing the correlation between returns, occasionally unrelated assets can appear to have a substantially higher level of correlation due to the daily measurements of returns or due to negative shocks creating a bias in the data. The correlation with EFA is fairly strong though. Investors using ECON would be wise to take advantage of temporary deviations by preparing a plan to rebalance in advance. Ideally that plan would focus on tolerance ranges rather than the frequency of rebalancing. In short, if they assigned a 5% allocation to ECON, they might rebalance the position whenever it exceeded 6% of the portfolio or fell below 4% of the portfolio. While I like the geographic diversification in this portfolio, it is not enough to justify paying a substantially higher expense ratio. Over the longer term, I think the best chance for this ETF to provide solid returns is for shareholders to plan to use the rebalancing strategy to ensure that they are buying in low and selling high. If an investor is willing to rebalance that way and accept modern portfolio theory, it would be ironic if they still felt that a very high expense ratio fund was going to offer superior returns over the long haul.