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The Generation Portfolio: W.P. Carey, AT&T, Verizon And 3M Company

Summary The Generation Portfolio is an account I manage to which I began adding stock positions in late August 2015. During this past week, I added positions in W.P. Carey, AT&T, Verizon And 3M Company. Looking ahead, it appears as if the volatility in the market will remain for the time being due to continued Fed reluctance to normalize interest rates and global economic issues. Background The Generation Portfolio is an account that I manage for others. I discuss its genesis here . I provide weekly updates, such as here , here and here . Previous to my involvement, it was an accumulation of random stocks built up over decades which had no underlying theme, many now worthless. I liquidated (with a few exceptions) those positions in the spring of 2015, and then began adding positions to the Generation Portfolio again in late August 2015. I manage the account for no compensation, but the experience has been very personally rewarding and it does give me something to write about. My hope is that this series will serve several purposes: It will illustrate the implementation of a true “buy on weakness” strategy in close to real time; It may provide some ideas for other investors, who are searching for a strategy or investments of their own and can learn from my successes and failures; Show in deed and not just in word that it pays off to buy Quality Stocks (as I defined that term) on weakness. It is easy to talk a good game about buying on weakness or buying “value” or buying whatever stock serves today’s agenda, mouthing empty words without consequence. That pretty much sums up the story of stock “analysis” on the Internet, and I have been reading about stocks online since 1994. However, my experience is that you usually only hear about great buys made by others long after they turned out well. So-so buys tend to not get mentioned so much, and ones that don’t work out well at all go straight down the Memory Hole from George Orwell’s “1984.” It is an old, old story that essentially never changes except among a very small group of transparent analysts. For better or worse, there is going to be strict accountability in this ongoing series. This series is going to show a specific value/income strategy as it evolves over time, examining both the winners and the losers. I hope it will prove useful to others considering similar strategies in the future. Of course, everyone must do their own due diligence and tailor their purchases and sales to their own goals, outlook and ever-changing market conditions. Previous Purchases During the week of 24 August 2015, I added the following positions: Wells Fargo (NYSE: WFC ); Disney (NYSE: DIS ); Bristol-Myers Squibb (NYSE: BMY ); MFA Financial (NYSE: MFA ). During the week of 31 August 2015, I added the following positions: Omega Healthcare (NYSE: OHI ); Chevron (NYSE: CVX ); Procter & Gamble (NYSE: PG ); CYS Investments (NYSE: CYS ). During the week of 7 September 2015, I added the following positions: Coca-Cola (NYSE: KO ); Medical Properties (NYSE: MPW ); Wal-Mart (NYSE: WMT ); Ventas (NYSE: VTR ); Kinder Morgan (NYSE: KMI ). Entering this week, and excluding legacy positions that I retained but did not initiate, the Generation Portfolio had 13 positions comprising about 26% of available trading funds. Summary of the Past Week The market volatility that began in August 2015 continued, providing some nice buying opportunities in Quality Stocks. As expected, the market was transfixed by the Fed meeting that concluded on 17 September 2015. The major averages rose into the meeting, had a brief but sharp spike higher after the Fed announced no change in policy, and then fell back to conclude the week essentially unchanged. General Strategy During the period of market turbulence that began in late August 2015, after keeping the Generation Portfolio 100% in cash for about six months, I finally began adding positions. I decided to use individual stocks and not just rely on index funds for reasons (among others) that I explained here . The focus of the Generation Portfolio is to provide stability while generating steady income, which to the extent possible will be used to add other positions, pay taxes and so forth. As I discussed in a previous article, I side with those who prefer wide diversification, both between sectors and within them. I would rather own smaller positions of two leaders in a sector rather than just place all of my hopes on just “the” leader. Accordingly, the Generation Portfolio is shaping up to have dozens of positions, each with a projected weighting of 2-3%. I believe in the importance of cash flow, so the overwhelming majority of positions will pay good dividends. I like the tax advantages and strong cash flow of REITs, so they will form a substantial subset of the Generation Portfolio. I have no problem at all about investing in to companies with similar risk profiles. It’s all about tactics, and bad tactics can ruin the best strategy. Most Recent Purchases During the week of 14 September 2015, I added the following positions: W.P. Carey, Inc. (NYSE: WPC ); AT&T Inc. (NYSE: T ); Verizon Communications (NYSE: VZ ); 3M Company (NYSE: MMM ). The Portfolio as it Stands Now Below is how the Generation Portfolio stands now. The Generation Portfolio as of 19 September 2015 Stock Purchase Date Purchase Price Recent Price Change since Purchase WFC 8/25/2015 51.75 51.06 (1.37%) DIS 8/25/2015 98.75 102.80 4.14% BMY 8/25/2015 59.75 65.99 8.03% MFA 8/25/2015 7.05 7.17 1.70% OHI 8/31/2015 33.95 33.93 2.36% CVX 9/02/2015 77.90 77.70 (0.21%) PG 9/03/2015 69.95 70.04 (0.01%) CYS 9/04/2015 7.68 7.51 (2.21%) KO 9/09/2015 38.50 39.01 1.25% MPW 9/10/2015 10.89 11.28 3.58% WMT 9/10/2015 64.40 63.40 (1.65%) VTR 9/10/2015 52.80 56.15 6.34% KMI 9/11/2015 29.95 30.64 1.67% WPC 9/15/2015 56.75 59.16 4.37% T 9/17/2015 32.50 32.50 0.15% VZ 9/17/2015 44.95 44.57 (0.85%) MMM 9/18/2015 139.90 140.29 (0.20%) Recent Prices are those supplied by my broker as of the close on 9/18/2015. A large legacy position in Ford Motor Company is omitted. Percentage changes since purchase are those supplied by my broker. There was a point on Thursday afternoon, immediately after the Fed meeting, when pretty much every single position was showing a profit. I should have taken a picture, because that isn’t likely to happen again any time soon. The percentage changes, supplied by the broker, conflict sometimes with the “last” prices it supplies. For instance, according to the last prices, PG and MMM should show a slight profit since purchase, and T should show as being flat. However, brokers have their ways, and the difference is probably accounted for by after-hours transactions. I am just going with what the broker (TD Ameritrade) reports, for better or worse. The percentage changes also do not account for stocks that have gone ex-dividend. CYS, for instance, went ex during the week, so it shows as a loss. However, when adding back in the dividend, it actually is one of the winners in the Generation Portfolio. Coke, of course, also went ex last week. As time goes by, I will begin accounting for dividends as they are received. With the four purchases made this week, the seventeen positions (less the legacy positions, which are not included in any calculations), based on initial purchase value and not subsequent price movements, now occupy 37.4% of the available trading funds. The position sizes are not all equal, as like most humans I prefer to trade in even lots, but they are of roughly equivalent total values. Analysis of Holdings While it may not appear like it from a quick glance at the table of holdings, it was a good week for the Generation Portfolio. Several positions went up by significant percentages, while the laggards had minimal losses. I went into the Fed meeting expecting no raise in rates, for the reasons set forth in some detail in my recent article “The September Jobs Report Does Not Support A Fed Rate Hike.” As can be seen from the holdings in the Generation Portfolio, it is heavily weighted toward REITs (CYS, OHI, VTR, WPC, MFA, MPW) that tend to benefit in the investing community’s view from lower rates. I even added the W.P. Carey position right before the Fed meeting based on that expectation. Banks can be expected to react poorly to lower rates, and the only such holding is Wells Fargo, which I think is a good value regardless of Fed action. The market, apparently, was leaning the other way, and the Fed non-action took it by surprise. The net effect on the Generation Portfolio was very positive. All of the REITs shot up in value, while the other holdings declined but held their values fairly well. It was amusing watching companies announce their upcoming dividends after the Fed announcement. It appeared that managers did not want to commit themselves until the Fed was out of the way, sort of like the two alternate newspaper headlines in ” Citizen Kane ” depending on whether Kane won or lost his election. W.P. Carey increased its dividend slightly on Thursday, and every little bit helps. The other major star of the week was Bristol-Myers Squibb. BMY rose from under 60 to almost 66, which for a sleepy pharmaceutical is spectacular. The reason appeared to be speculation about a takeover. Guy Adami on CNBC’s “Fast Money” show has been dropping hints about BMY all week. I did not buy BMY as a takeover play, but would be happy to go along for the ride. General Discussion To echo a recent popular tune, it’s all about the interest rates, the interest rates, the interest rates. As I noted in my article about the jobs report, global effects simply cannot be ignored these days. There are very practical reasons for this which the Fed – quite wisely – has begun giving significant weight. The common refrain from bond traders is that interest rates are too low. In fact, they are too high. (click to enlarge) Source: CYS Investments Form 8-K filing for presentation at Barclays financial services conference on the morning of 17 September 2015. While interest rates are at historically low levels for US markets, in fact they are much higher than in other major economies. I discussed the factors affecting Fed policy in some detail in my February 2015 article “The Case for REITS in 2015” and a follow-up in July 2015. To summarize, having US rates out of alignment with global interest rates would hurt US exports by strengthening the US Dollar. With an iffy job market as I discussed in my article on the September jobs report, and no inflation, raising rates could not only not help the economy, it could damage it severely. Simply put, the US no longer dominates the global economy as it once did when other nations had been destroyed by World War II. That decline has accelerated in recent years. The US can no longer simply set its own rules and expect the rest of the world to adjust accordingly. Listening to Fed Chair Janet Yellen’s speech, she emphasized repeatedly that global economic developments and the absence of inflation were the prime factors behind the Fed not raising interest rates. She also said that, ceteris paribus (economist-speak for “all else being equal”), the Fed would need evidence of improvement in the labor market before it would take any action. As I discussed in relation to the September jobs report, not only is the labor market not improving as much as some appear to think, in fact job growth has declined in recent months. It is hard to see how conditions overseas that prevented a Fed hike in September are going to mysteriously clear up by December. It also is difficult to predict that conditions in the labor market will improve significantly in that time. To be fair, inflation may appear to pick up in coming months as the dramatic declines in energy prices of late 2014 roll off the annual price increase measures. However, the Fed is smart enough not to rely on such obvious statistical artifacts in making long-term, forward-looking policy. Chair Yellen said that the Fed does not expect inflation to hits its 2% target until 2018, which implies that there will be no need for a rate hike any time soon, and certainly not in the near term. There is a conundrum here, as Janet Yellen’s stated reasons for no hike in September conflict with her abstract comments that the Fed Board of Governors still expects to raise in 2015. You cannot expect a short-term reversal of long-term trends such as global deflation. In other words, the uncertainty continues. I play it as it lays, to use a golfing term. The Fed, despite all “moral suasion” to the contrary, is in no hurry to raise rates. Whether or not I agree with that is irrelevant, but I will point out that uncertainty about rates leads to mis-allocation of capital. It would be better for the economy if the Fed either set some kind of firm data requirement for it to take action (“when the CPI tops .3% for three months in a row” or something along those lines), or stopped its members and Chair from implying that it might raise rates under some ambiguous and nebulous “analysis” of its own devise. However, it is possible to make a judgment based on what the Fed has done instead of said. Unless there are significant improvements in the stream of economic data that the US government releases in coming months, and that places like China release as well, I expect no rate hike in 2015. Put me down firmly in the 2016 camp. One other consideration is the status of the current business cycle. The economy is chugging along, slowly but steadily. The current expansion, as the White House likes to note , now has hit 66 months (omitting the quarter of negative GDP growth in early 2014). This is far longer than the post-war average of 58 months. If you go back further in time, the length of the current expansion appears out of alignment with historical precedent. One can make the argument that modern economic policy has lengthened the business cycle, that specific policies can stretch out the length of an expansion at the cost of its strength, and that the sharp recession of 2008-2009 laid the foundation for an especially prolonged period of growth. However, at some point the economy will experience weakness again, and the market will start noticing. Thus, I will remain very conservative in my stock choices for the time being and avoid growth stocks that pay no dividends. Stocks Under Consideration This is a general list of the stocks I am considering. While I also watch other stocks and am opportunistic, these should give some idea of what is near the top of the list. Many of my previous buys have come straight off this list. (NYSE: ABT ), (NASDAQ: AGNC ), (NYSE: BPL ), (NYSE: CAH ), (NYSE: CAT ), (NYSE: CL ), (NYSE: COP ), (NYSE: CSX ), (NYSE: CY ), (NYSE: DE ), (NYSE: DLR ), (NYSE: EV ), (NYSE: EMR ), (NYSE: FCX ), (NYSE: GE ), (NASDAQ: GILD ), (NYSE: GIS ), (NYSE: GS ), (NYSE: HD ), (NYSE: HON ), (NYSE: JNJ ), (NYSE: JPM ), (NYSE: KKR ), (NYSE: KMB ), (NYSE: LMT ), (NYSE: MAIN ), (NYSE: MO ), (NYSE: MS ), (NASDAQ: NFLX ), (NYSE: NKE ), (NYSE: NNN ), (NYSE: NSC ), (NYSE: O ), (NYSE: OXY ), (NYSE: PANW ), (NYSE: PBY ), (NYSE: PEP ), (NYSE: PFE ), (NYSE: PM ), (NYSE: PSX ), (NYSE: RDS.B ), (NYSE: RTN ), (NYSE: SCG ), (NYSE: STAG ), (NYSE: KSS ), (NYSE: SDRL ), (NYSE: STWD ), (NYSE: TOL ), (NYSE: UNH ),(NYSE: UNP ), (NYSE: UTX ), (NYSE:), (NYSE: XOM ). Actionable Ideas Given my judgment that the Fed will keep rates low for the foreseeable future, I will continue to emphasize rate-sensitive stocks such as REITs in the Generation Portfolio. However, banks sold off hard after the Fed announcement because investors perceive them as being the beneficiaries of higher rates, so there may be opportunities in stocks such as GS, JPM and MS after the market fully digests the Fed decision. In addition, general market weakness may provide some opportunities in stocks like GIS and CL. Energy stocks remain at the top of the list due to their astounding sell-off over the past year. Earnings season now is just around the corner, and the prospect of a government shut-down looms, so the market volatility should continue and provide good stock-picking openings. Conclusion As expected, the Fed did not raise interest rates in September 2015 due to global economic issues and the lack of domestic inflation. Those issues do not appear likely to evaporate any time soon. Following a preference for rate-sensitive REITs has paid off for the Generation Portfolio, and there is no need to alter that strategy. However, opportunities in the banking and related fields may present themselves in coming days and weeks as the market digests the lack of Fed action. With earnings season coming up, it is a good time to review lists of candidates for addition to the portfolio and plan accordingly. Disclosure: I am/we are long CYS, MPW, WMT. (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: While I personally only own the stocks listed in the disclosure, the Generation Portfolio which I manage owns all the stocks indicated as such in the article.

XLY: Do You Need More Aggressive Allocations?

Summary XLY offers investors a fairly aggressive portfolio that is more volatile than the market but benefits from diversification. Most of the allocations seem very reasonable, but MCD looks like a fairly conservative option. If an investor is going to buy into this aggressive fund, they should have a rebalancing plan in place. 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. One of the funds that I’m reviewing is the Consumer Discretionary Select Sector SPDR ETF (NYSEARCA: XLY ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so the goal is to design portfolios that perform well on a risk adjusted basis, not portfolios that necessarily beat the market. Expense Ratio The expense ratio for XLY is .15%. That isn’t too bad. I’m usually expecting to see high expense ratios that drain away the investor’s money, but XLY scores well in this regard. Largest Holdings (click to enlarge) The top of the holdings for XLY is Amazon (NASDAQ: AMZN ). For investors seeking to find companies trading at low fundamentals such as P/E ratios, Amazon’s history of not turning a meaningful profit may be a concern. While earnings are a concern for Amazon, sales have been an area of strength as the company blossomed over the last 15 years and has become a household name. The difficulty for this portfolio is the reliance on discretionary spending. This is a reason for the portfolio to show some substantial volatility when investors are concerned about another recession and falling personal expenditures. The interesting holding here is McDonald’s (NYSE: MCD ) coming in as the 5th holding. I would not put MCD in the same category as the other top holdings. MCD pays a very strong dividend, has a long history of doing so, and in a bad economy the restaurant can pick up new customers that are trading down to buy McDonald’s products rather than more expensive food. The rest of the top 10 holdings are all companies that I would expect to perform best when consumers are readily disposing of income. Building the Portfolio This hypothetical portfolio has a fairly aggressive allocation for the middle aged investor. Only 25% of the total portfolio value is placed in bonds and a fifth of that bond allocation is given to high yield bonds. If the investor wants to treat an investment in an mREIT index as an investment in the underlying bonds that the individual mREITs hold, then the total bond allocation would be 35%. Given how substantially mREITs can deviate from book value, I’d rather consider the allocation as an equity position designed to create a very high yield. This portfolio is probably taking on more risk than would be appropriate for many retiring investors since a major recession could still hit this pretty hard. If the investor wanted to modify the portfolio to be more appropriate for retirement, the first place to start would be increasing the bond exposure at the cost of equity. However, the diversification within the portfolio is fairly solid. Long term treasuries work nicely with major market indexes and I’ve designed this hypothetical portfolio without putting in the allocation I normally would for equity REITs. An allocation is created for the mortgage REITs, which can offer some fairly nice diversification relative to the rest of the portfolio and they are a major source of yield in this hypothetical portfolio. 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 35.00% 2.06% Consumer Discretionary Select Sector SPDR ETF XLY 10.00% 1.36% First Trust Consumer Staples AlphaDEX ETF FXG 10.00% 1.60% Vanguard FTSE Emerging Markets ETF VWO 5.00% 3.17% First Trust Utilities AlphaDEX ETF FXU 5.00% 3.77% SPDR Barclays Capital Short Term High Yield Bond ETF SJNK 5.00% 5.45% PowerShares 1-30 Laddered Treasury Portfolio ETF PLW 20.00% 2.22% iShares Mortgage Real Estate Capped ETF REM 10.00% 14.45% Portfolio 100.00% 3.53% The next chart shows the annualized volatility and beta of the portfolio since April of 2012. (click to enlarge) A quick rundown of the portfolio Using SJNK offers investors better yields from using short term exposure to credit sensitive debt. The yield on this is fairly nice and due to the short duration of the securities the volatility isn’t too bad. PLW on the other hand does have some material volatility, but a negative correlation to other investments allows it to reduce the total risk of the portfolio. FXG is used to make the portfolio overweight on consumer staples with a goal of providing more stability to the equity portion of the portfolio. FXU is used to create a small utility allocation for the portfolio to give it a higher dividend yield and help it produce more income. I find the utility sector often has some desirable risk characteristics that make it worth at least considering for an overweight representation in a portfolio. VWO is simply there to provide more diversification from being an international equity portfolio. While giving investors exposure to emerging markets, it is also offering a very solid dividend yield that enhances the overall income level from the portfolio. XLY offers investors higher expected returns in a solid economy at the cost of higher risk. Using it as more than a small weighting would result in too much risk for the portfolio, but as a small weighting the diversification it offers relative to the core holding of SPY is eliminating most of the additional risk. REM is primarily there to offer a substantial increase in the dividend yield which is otherwise not very strong. The mREIT sector can be subject to some pretty harsh movements and dividends from mREITs should not be the core source of income for an investor. However, they can be used to enhance the level of dividend income while investors wait for their other equity investments to increase dividends over the coming decades. If you want a really quick version to refer back to, 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 Consumer Discretionary Select Sector SPDR ETF XLY Enhance Expected Returned First Trust Consumer Staples AlphaDEX ETF FXG Reduce Beta of Portfolio Vanguard FTSE Emerging Markets ETF VWO Exposure to Foreign Markets First Trust Utilities AlphaDEX ETF FXU Enhance Dividends, Lower Portfolio Risk SPDR Barclays Capital Short Term High Yield Bond ETF SJNK Low Volatility with over 5% Yield PowerShares 1-30 Laddered Treasury Portfolio ETF PLW Negative Beta Reduces Portfolio Risk iShares Mortgage Real Estate Capped ETF REM Enhance Current Income Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. Despite TLT being fairly volatile and tying SPY for the second highest volatility in the portfolio, it actually produces a negative risk contribution because it has a negative correlation with most of the portfolio. It is important to recognize that the “risk” on an investment needs to be considered in the context of the entire portfolio. 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 TLT’s heavy negative correlation, it receives a weighting of 20% and as the core of the portfolio SPY was weighted as 50%. 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 XLY offers investors a fairly aggressive allocation that is heavy on companies that should succeed when the market is doing well and should struggle more during a market downturn. To take advantage of the investment investors would want to be ready to buy into the ETF when fear is stronger in the economy. In my opinion, the most effective way to do that would be to set up an automatic rebalancing schedule or use allocation bands and buy in/sell off whenever the allocation was exceeding the desired range. Due to some diversification benefits, a small allocation can be used in a portfolio without driving up the total risk of the portfolio. However, investors aiming to use the ETF for more than 10% or so of the portfolio may find their volatility across the portfolio increasing. An investor could counteract some of that additional risk by increasing their allocation to treasury securities with an ETF like PLW where the correlation between the two funds is a negative .4. Despite a fairly low expense ratio, if an investor is using a large enough portfolio they may still find it worthwhile to imitate the portfolio by buying up the major holdings because so much of the portfolio is held in the top 10. For the investor that wants to get a little more aggressive without a large enough portfolio to replicate XLY, it looks like a fairly solid option for the sector. 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.

FFFDX: A Target Date Fund In Need Some Work

Summary FFFDX offers investors a high expense ratio to go with a needlessly complex portfolio. Investors seeking superior risk adjusted returns could go with allocations as simple as SPY + any long term treasury ETF. By incorporating an enormous volume of other mutual funds the target date fund incorporates a higher expense ratio with suboptimal holdings. If the fund needs exposure to the total US market, they can ditch the complicated combination of funds and just use FSTVX (Disclosure: long 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 2020 Fund (MUTF: FFFDX ). What do funds like FFFDX 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 FFFDX 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 FFFDX. Expense Ratio The expense ratio of Fidelity Freedom® 2020 is .66%. 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 (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. Holdings / Composition The following chart demonstrates the holdings of Fidelity Freedom® 2020: 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. For comparison, Vanguard’s Target Retirement 2020 Fund (MUTF: VTWNX ) includes only five allocations and one of them is less than one percent. Volatility An investor may choose to use FFFDX 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 FFFDX, it is dramatically lower than the volatility on the SPDR S&P 500 Trust ETF (NYSEARCA: 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. Despite that expectation, for having a beta of .56%, delivering less than half the gains of the S&P 500 is really sad. It isn’t like the portfolio simply has an enormous amount of cash sitting around. A target date fund should have a substantial allocation to treasury securities. As you might recall, treasury securities did fairly well. Over the last five years the iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) was up 36.4%. Want lower volatility with better annualized returns? Simply combine TLT and SPY as demonstrated in this hypothetical portfolio: (click to enlarge) This portfolio produces a lower level of annualized volatility and superior returns despite having only two tickers. SPY provided domestic equity and TLT provided long term treasury exposure. The reason to have a target date portfolio is so that it is automatically readjusted over time to reduce risk (at the cost of expected return). 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 – Fidelity Advantage Class (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. 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%. FFFDX 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. Disclosure: I am/we are long FSTVX. (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.