Park Your Money in Four ETFs To Cut Market Exposure

By Path Financial President and Chief Investment Officer Raul Elizalde

raul imageFrom time to time investors look at reducing their market exposure and “parking” their money safely. Some choose plain cash, but cash has a negative real rate – it does not grow, and inflation eats away at its value.

Some ETFs can provide stability and a moderate return with very low exposure to market risk. While no investment is completely safe (even cash under a mattress can catch fire) these ETFs have solid sponsors, large portfolios and plenty of liquidity. Each one has different characteristics, so using them in combination may be better than settling on any single one.

SHY, for example, has $14 billion of U.S. Treasury notes and bonds with maturities between 1 and 3 years. Its liquidity is excellent and its sponsor, BlackRock’s iShares, is one of the strongest financial institutions around. Because all its holdings are in fixed-rate instruments, its value declines when interest rates go up. Quality is unmatched: the assets are backed by the full faith and credit of the United States Government.

FLOT, also from iShares, has $10 billion of floating-rate securities issued mostly by corporations with an average maturity of about 2 years. These underlying instruments pay interest that moves with market rates, so they tend to benefit when rates climb. Like SHY, it is a very liquid ETF.

CSJ is another iShares ETF. It resembles SHY in that it contains $11 billion in fixed-rate instruments with maturities between 1 and 3 years, but it is mostly comprised of corporate securities, which pay higher rates than the US Treasuries in SHY. Like SHY, its value tends to drop when rates go up. Roughly 16% of its portfolio is made up of supranational and government-guaranteed bonds.

Finally, SPSB is an ETF sponsored by State Street’s SPDRs, another very strong sponsor. Like CSJ, it contains corporate bond holdings between 1 and 3 years. However, there are no supranational or government-guaranteed bonds among its $4 billion in assets, which results in a higher return than CSJ but also higher volatility. Both CSJ and SPSB offer plenty of liquidity with very narrow bid-ask spreads, but their daily volumes are smaller than SHY or FLOT.

We ran a few combinations of these ETFs using approximately seven years of data, looking for an optimal blend of low volatility, high return and minimal drawdowns (i.e. declines from peaks) for that period. A mix that seems to satisfy these elements is a 65% FLOT, 10% SHY, 15% CSJ and 10% SPSB allocation rebalanced monthly, as shown in the graph below. Drawdowns and volatility were minuscule. Returns were moderate, as one would expect for a cash alternative, but accelerated in the last two years as rates rose.

graph one

We tried including other short-term and floating-rate ETFs such as BSV (Vanguard’s short-term bond ETF) and FLRN (State Street’s SPDR Floating Rate) but we found no measurable contribution to the portfolio metrics achievable with the four ETFs we focused on.

While this mix worked well in the past, the optimal blend going forward may contain a larger proportion of FLOT if rates rise, or a smaller proportion of CSJ and SPSB if credit spreads widen along with lower equity prices.

A word of caution: ETFs, like any instrument, can be subject to liquidity constraints. Unlike a mutual fund, owning an ETF does not give the holder direct ownership to the underlying instruments. A serious market dislocation can affect corporate bonds spreads and cause FLOT, CSJ, or SPSB to experience significant price drops or a wide gap between market value and net asset value.

However, barring the unknowable effects of abnormal market conditions, which in any case tend to be temporary, these ETFs offer investors an attractive alternative to cash.

This analysis originally appeared in Raul Elizalde’s Forbes.com investment column. Click here to follow Raul on Forbes.

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Raul Elizalde President Path FinancialRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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Business sectors are set for massive changes this fall

By Path Financial President and Chief Investment Officer Raul Elizalde

2018-06-04 14_05_27-Sector ETFs Are Set For Massive Changes This FallThe Global Industry Classification Standard (GICS) is a taxonomy system developed by MSCI and Standard & Poor’s that organizes companies into 11 economic sectors. This classification is applied to sector indices, which are in turn used to build ETFs and mutual funds that track them.

But the GICS system was created almost 20 years ago, and the world has changed a lot since then.

Facebook, for example, is no longer the online curiosity it was when it first started. It is now a huge delivery system for content, marketing and advertising. So it no longer seems appropriate that it should coexist in the same “information technology” box as Akamai, for example, which builds internet delivery networks and focuses on security and reliability.

To accommodate these changes the good folk at GICS have produced a preliminary list of more than 200 companies around the world that will be reclassified to reflect better what they actually do today. A final list will be published in July, and changes will be effective in September.

The technology sector will lose many big names to a new communications sector (a rebranding of the current telecommunications sector) such as Alphabet, Google and Twitter. Consumer discretionary will lose Comcast, Disney and Twenty-First Century Fox to communications as well.

These huge changes will fundamentally change the technology, communications and consumer discretionary sectors. Investors unaware of these changes will be in for a big surprise.

For example, the market cap of the communications sector will jump from today’s $1.7 trillion to perhaps as much as $10 trillion, according to a study from State Street, one of the largest ETF providers. Consumer discretionary and technology will shrink.

Additionally, as the State Street study points out, communications will be far more correlated to the S&P 500 than before. It will also include 13 stocks in the top 50% of returns in 2017, a huge change for a sector that today has a large proportion of high-dividend, defensive stocks. Furthermore, historical studies of sector volatility and correlation will be rendered largely useless. Investors who strive to build efficient portfolios using that data will find themselves in the dark.

ETFs, which have been the investors’ vehicle of choice to track indices, will be particularly affected. For example, State Street’s SPDR Technology Sector XLK, Consumer Discretionary XLY and Telecommunications XTL that track the S&P Select Sector indices (built around GICS) will be revamped to mirror the new compositions.

Vanguard, which also has sector ETFs (the Technology VGT, Telecommunications VOX and Consumer Discretionary VCR) structured as a class of their mutual funds adopted an interesting approach. Between May and September they will track custom MSCI Investable Market Transition indices to avoid sudden changes to the funds, in lieu of the current MSCI Investable Market Indices.

Fidelity’s U.S. sector ETFs track U.S.-only versions of the MSCI Investable Market Indices, which will change as well. On the other hand, some of Blackrock’s US-only sector ETFs will be unaffected, such as the Technology IYW and the Telecommunications IYZ, because they track US-only Dow Jones Sector indices that are not aligned with GICS. Adding to the confusion, Blackrock’s global sectors ETFs such as the Global Telecom IXP are linked to GICS definitions, and will change.

This is enough to make any investor’s head spin. What investors must remember is that some of the sector funds they use today may no longer represent their investment objectives after September. Keeping abreast of the upcoming changes will go a long way to avoid surprises down the road.

This analysis originally appeared in Raul Elizalde’s Forbes.com investment column. Click here to follow Raul on Forbes.

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Raul Elizalde President Path FinancialRaul Elizalde is the Founder, President, and Chief Investment Officer of Path Financial, LLC. He may be reached at 941.350.7904 or raul@pathfinancial.net.

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