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Summary VDC has a reasonable correlation with SPY and less volatility. The heavy focus on consumer staples resulted in the fund performing substantially better on risk-adjusted metrics. Using VDC as a portion of the equity portion of a portfolio would be appropriate for the majority of investors. I’m glad Schwab and Vanguard have been competing to offer the lowest cost funds, but I’d love to have VDC added to my “Free to trade” list. 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. The Vanguard Consumer Staples ETF (NYSEARCA: VDC ) ETF looks like an interesting option for risk reduction. 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 maximize risk-adjusted returns by minimizing risk without destroying the potential for returns by being too conservative or spending too much on trading costs or high expense ratios. Does VDC provide diversification benefits to a portfolio? Each investor may hold a different portfolio, but I use SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) as the basis for my analysis. I believe SPY, or another large cap U.S. fund with similar properties, represents the reasonable first step for many investors designing an ETF portfolio. Therefore, I start my diversification analysis by seeing how it works with SPY. I measured correlations using daily and monthly returns over five-year periods and two-year periods. Depending on the measurement periods and intervals, the correlation will generally run around 75% to 80%. The correlation is low enough that there is the potential for a reduction in risk. When I checked the volatility of the ETF over the last five years, the annualized volatility was 11.1%, which compares very favorably with the S&P 500 having an annualized volatility of 14.8%. On top of the low correlation and lower volatility, the max drawdown for the period was -11.2%. The worst drawdown for SPY in that range was -18.6%. By any risk measurement, VDC should be seen as a lower risk option for the portfolio. Returns were not destroyed either. VDC outperformed SPY during the holding period by 1% with gains of 115.1% compared to 114.1%. So far, VDC is looking fairly impressive. Yield & Taxes The yield is only 1.85%, which is not ideal for retiring investors seeking stronger yields from their portfolio, but the volatility numbers are excellent for investors that want lower levels of risk in their portfolio. Expense Ratio The ETF is posting .12% for an expense ratio (both gross and net). I want diversification, I want stability, and I don’t want to pay for them. I view expense ratios as a very important part of the long-term return picture because I want to hold most of my investments for a time period measured in decades. The .12% expense ratio is solid and it gives investors a good value on their investment. Largest Holdings The diversification within the ETF is not a selling point for me. The top position being over 10% is the antithesis of diversification, but Procter & Gamble (NYSE: PG ) do have quite a bit of diversification within the company, so the concentration of the position within one company is not as bad as it might seem at first. Coca-Cola (NYSE: KO ) and PepsiCo (NYSE: PEP ) being the next two provides me a little concern again because the portfolio is holding 15% of the value in these fairly similar companies. Despite that, they are both solid companies with global distribution and enormous product lines. Phillip Morris (NYSE: PM ) is selling products that are literally addictive and Wal-Mart (NYSE: WMT ) is a fairly large piece of the retail pie. Despite the concentration to a few of the companies at the top, the portfolio is still quite intelligent given that the ETF is being restricted to the “Consumer Staples” sector. Absent an enormous scandal at one of the large companies, the diversification within product lines should provide material protection from weakness in the economy. (click to enlarge) Conclusion This is simply a great ETF. If the ETF used a higher distribution yield to push more cash back into the hands of investors, it might be one of the best core holdings a retiring investor could find for reducing their risk on the equity side of the portfolio. Absent the high distribution yield, the fund is still a very solid choice for any long-term investor with a higher level of risk aversion. Even for those with only moderate levels of risk aversion, it would make sense to be a little overweight on consumer staples. The downside for investors that don’t have free trading on the ETF is that optimal use of the ETF would involve rebalancing the portfolio occasionally to ensure the weightings across the portfolio remain within a reasonable tolerance band. My estimates on reasonable allocations for a highly risk-averse investor would be running 20% to 30% of the equity portion of the portfolio. Note that this is specific to the equity portion; the investor would still need to determine their own bond to equity ratios and adjust accordingly. For the investor with a lower emphasis on reducing portfolio risk, the fund would still be a very reasonable allocation for 5% to 10% of the equity portfolio if the investor has free trading on it. The only real downside I see here for investors that are not taking distributions (so yield won’t matter) is that the fund is only going to be free to trade with certain brokerage companies. That’s a shame because this fund is such a solid holding under modern portfolio theory that it could be stuck into most real investor’s portfolios to improve the expected risk/return. If this fund were on my “free to trade” list, I’d be adding a small allocation to my portfolio. 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. Scalper1 News
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