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Summary TLT is a high-duration treasury ETF. The expense ratio of .15% is within reason and the yield of 2.66% is enough to generate a small amount of income. The main reason for holding a fund like TLT is to keep portfolios values steady when equity markets fall on fear. TLT has a negative correlation with most equity investments and a negative correlation with short term high yield bond funds. 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. I’m working on building a new portfolio and I’m going to be analyzing several of the ETFs that I am considering for my personal portfolio. One of the funds that I’m considering is the iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ). 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 on TLT is .15%, which is within reason for long term treasury ETFs. I’d love to see expense ratios dipping towards single digits, but this is still within reason. Yield The yield on the fund is 2.66%. This is lower than investors would expect from even a short term high yield fund, but it does provide some income in exchange for investors taking on the duration risk which can cause TLT to be fairly volatile. Maturity The maturity profile for TLT is fairly simple, as shown below. Over 98% of the portfolio is in treasury securities with a maturity of at least 20 years. Given the name of the ETF, that shouldn’t be a surprise. Similarly, the fund is pretty much exclusively treasury securities. No surprises in this category. Building the Portfolio This hypothetical portfolio has a moderately aggressive allocation for the middle aged investor. Only 30% of the total portfolio value is placed in bonds and a third of that bond allocation is given to high yield bonds. This portfolio is probably taking on more risk than would be appropriate for many retiring investors since the volatility on equity can be so high. 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 REITs on the assumption that the hypothetical portfolio is not going to be tax exempt. Hopefully investors will be keeping at least a material portion of their investment portfolio in tax advantaged accounts. 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. (click to enlarge) A quick rundown of the portfolio The two bond funds in the portfolio are TLT and the PIMCO 0-5 Year High Yield Corporate Bond Index ETF (NYSEARCA: HYS ) for high yield shorter term debt and for longer term treasury debt. TLT should be useful for the highly negative correlation it provides relative to the equity positions. HYS on the other hand is attempting to produce more current income with less duration risk by taking on some credit risk. The Consumer Staples Select Sector SPDR ETF (NYSEARCA: XLP ) is used to make the portfolio overweight on consumer staples with a goal of providing more stability to the equity portion of the portfolio. The iShares U.S. Utilities ETF (NYSEARCA: IDU ) is used to create a significant 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. The iShares MSCI EAFE Small-Cap ETF (NYSEARCA: SCZ ) is used to provide some international diversification to the portfolio by giving it holdings in the foreign small-cap space. The core of the portfolio comes from simple exposure to the S&P 500 via the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ), though I would suggest that investors creating a new portfolio and not tied into an ETF for that large domestic position should consider the alternative by Vanguard, the Vanguard S&P 500 ETF (NYSEARCA: VOO ), which offers similar holdings and a lower expense ratio. I have yet to see any good argument for not using or another very similar fund as the core of a portfolio. In this piece I’m using SPY because some investors with a very long history of selling SPY may not want to trigger the capital gains tax on selling the position and thus choose to continue holding SPY rather than the alternatives with lower expense ratios. 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 and with the S&P 500. 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. When it comes down to it, TLT shines in a portfolio. In a vacuum, TLT would be a fairly poor investment due to its high volatility and mediocre yield. Being over 2.6% means the income is material, but for most investors that yield is not going to cover a large portion of their living expenses and unlike dividend growth funds this won’t be rapidly compounding unless the position is increasing in value from yields falling. The additional total return would be nice, but it would leave investors with even fewer options for trying to produce material amounts of income to support their lifestyle. By including TLT in a portfolio that is heavy on equities the risk/return profile is materially improved. A strong negative correlation with equity investments means TLT generally moves up when those investments are falling in value. The combined portfolio exhibits substantially less volatility than the domestic equity market. While high volatility for an individual holding can often be considered a bad thing, negative correlations with so many other investments completely reverses the impact. Look at the chart below to see how much higher the total risk profile of the portfolio would have been if the position in TLT had been placed in SPY instead: (click to enlarge) The date range used is the same, but the annualized volatility of the portfolio has increased from 9.4% to 13.7% because this portfolio lacks balancing effect of TLT using a negative correlation to keep portfolio values steady when investors are fleeing the equity market to buy up long term treasury securities. Conclusion TLT is offering most of the things I’m looking for in a long term bond fund. The fund has high volatility, but the low correlation with the market results in a beta of negative .55. When I’m looking for long term bond funds my first areas to consider are the expense ratio and whether the fund is eligible for free trading. Unfortunately, TLT does not fall on my list for free trading which is a significant problem since I want to be regularly rebalancing the positions which means much higher trading fees if the ETF is not eligible for free trading. Despite that one weakness, TLT does well on every other metric. It offers a solid negative beta and enough income to feel like it is in the portfolio for more than just the negative beta. This is a very respectable ETF for long term treasury exposure. 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: TLT has a negative correlation with most equity investments and a negative correlation with short term high yield bond funds Scalper1 News
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