Category: Periodic commentary

ETFMathGuy provides periodic commentary on risks and opportunities of investing in Exchange Traded Funds (ETFs), including recent market trends.

ETFMathGuy is a subscription based education service providing commission-free ETF optimal portfolios. We offer individual investors insights into building optimal portfolios.  Each month, we analyze hundreds of commission-free ETFs available to individual investors.  Then, we build optimal portfolios based on a variety of risk tolerances and current market conditions using a quantitative methodology.

We hope these periodic commentaries on ETFs help you improve your investment knowledge!

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Taxation and your ETF investments

Taxation of your ETF investments is an important consideration. As we discussed in our previous post ETF Tax Efficiency vs. Mutual Funds, ETFs are quite tax efficient. Here, we summarize taxation of your ETF investments when held in a taxable account.

ETF taxation occurs in two ways. First, taxes occur when an ETF issues a dividend. Also, taxes occur when an investors sells their ETF for a gain (or loss). So, let’s first look at the preferred (lower) level of taxation available for ETFs.

ETF taxation of qualified dividends and long-term capital gains

ETFs issue two types of dividends, called qualified and non-qualified. As shown below, ETF investors prefer taxation of qualified dividends, due to their lower capital gains rates. Many stock-based ETFs issue these types of dividends. For example, the iShares core S&P 500 index ETF (ticker: IVV) currently distributes a qualified dividend yield of 2.05%. Investors who buy an ETF and sell it at least one year later also realize these preferred rates.

Tax rates for qualified dividends and long-term capital gains. source: https://taxfoundation.org/2019-tax-brackets/
Tax rates for qualified dividends and long-term capital gains.
source: https://taxfoundation.org/2019-tax-brackets/

ETF taxation as ordinary income

Unfortunately, ETFs can also be taxed at the higher rate of ordinary income. The tables below shows the current rates and income brackets for unmarried, married, and head of household tax payers.

Tax rates for non-qualified dividends and short-term capital gains. source: https://taxfoundation.org/2019-tax-brackets/
Tax rates for non-qualified dividends and short-term capital gains.
source: https://taxfoundation.org/2019-tax-brackets/

ETF investors face these taxes when either the ETF issues a non-qualified dividend, or is bought and sold in less than one year. Most bond-based ETFs issue non-qualified dividends. For example, the iShares Core U.S. Aggregate Bond ETF (ticker: AGG) generates non-qualified dividends, currently with a yield to maturity of 2.52%.

Don’t let the “tail wag the dog”

While taxation is an important aspect of ETF investing, it should not be the sole consideration. Indeed, Federal taxes could be minimized if one only needs the interest payments from municipal bond ETFs, like the iShares National Muni Bond ETF (ticker: MUB). But, a diversified portfolio should have a variety of asset classes. Instead, consider holding your portfolio of ETFs in a retirement account like a traditional or Roth IRA.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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August 2019 portfolios are now available based on our current low volatility markets

The August 2019 optimal portfolios are now available to subscribers of ETFMathGuy. So, please log in and select your discount broker to see the effect of current market conditions on our optimal portfolios. In this post, we highlight the effect of the recent low market volatility on portfolio turnover.

Low volatility is here, for now…

As discussed in yesterday’s Wall Street Journal article entitled “Markets are Eerily Quiet Right Now“, market volatility has been quite low recently. For the past 35 days, the S&P 500 hasn’t changed by more than 1%. Consequently, the August 2019 portfolios won’t differ much from the previous month. For instance, consider the Vanguard moderate portfolios generated over the past two months.

Vanguard optimal portfolios the Month of July, 2019, Moderate Risk Level
Vanguard optimal portfolios the Month of July, 2019, Moderate Risk Level
Vanguard optimal portfolios the Month of August, 2019, Moderate Risk Level
Vanguard optimal portfolios the Month of August, 2019, Moderate Risk Level

As these simpler portfolios demonstrate, low volatility produces less turnover. Here, none of the portfolio weights changed by more than a few percent.

Where will the stock and bond markets go from here?

Frankly, we don’t know, as we believe that markets are generally efficient. Market volatility will certainly return to a more typical level at some point in the future. But, when will this occur? Perhaps volatility will pick up when many professional traders return from summer vacation? Or, perhaps markets will stay quiet until the start of the next earnings season?

In any event, when market volatility does return, our monthly portfolio updates will pick up these dynamics and generate a new set of optimal portfolios. We hope you will stay tuned!

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Stocks and Bonds in an ETF portfolio over the long-term

Stocks and bonds carry many benefits when held over the long term. In this post, I highlight a few aspects that are important to individual investors.

Two of the largest stock and bond ETFs analyzed each month by ETFMathGuy follow the tickers symbols IVV and AGG. IVV tracks the S&P 500 index, which consists of large U.S. companies. The top 10 holdings of IVV appear below.

Top 10 holdings of the iShares Core S&P 500 ETF. Source: etf.com/ivv
Top 10 holdings of the iShares Core S&P 500 ETF. Source: etf.com/ivv

The ticker symbol AGG tracks the Bloomberg Barclays U.S. Aggregate Bond Index. As we discussed in our previous post on the “Fundamentals of Fixed Income ETFs“, quality and maturity are two important components. The quality component of this ETF is largely influenced by its 40% of holdings of U.S. government bonds, and over 20% of mortgage backed securities. Top sector holdings appear below.

Top 10 sector holdings of the iShares Core U.S. Aggregate Bond ETF . Source: etf.com/agg
Top 10 sector holdings of the iShares Core U.S. Aggregate Bond ETF . Source: etf.com/agg

The bonds in AGG have an average maturity of about 8 years. Consequently, interest rate changes generally affect its price more than similar bond ETFs with shorter maturities.

Long term returns of stocks and bonds

The fundamental information about stock and bond ETFs is important, but doesn’t really address long-term investment performance. For that, consider the following chart that shows the total return of $100,000 invested in either the stock (green) or bond (blue) ETFs mentioned previously.

Total return of $100,00 invested in IVV (green) and AGG (blue) from January 5, 2004 to July 19, 2019. source: ETFReplay.com
Total return of $100,00 invested in IVV (green) and AGG (blue) from January 5, 2004 to July 19, 2019. source: ETFReplay.com

As this chart shows, much better returns are possible with stocks, provided investors are willing to accept the higher volatility. Annual growth rate of the stock ETF (IVV) is more than double (8.7% versus 4.0%) than the bond ETF (AGG). But, the volatility of the stock ETF is nearly four times (4X) larger than the volatility of the bond ETF.

Asset allocation basics

So, what is the correct allocation between stocks and bonds using ETFs? Generally speaking, investors seeking less risk will seek more bonds and less stock exposure. One simple rule of thumb is the “120-age” formula for stocks. So, a 30-year old investor would be 90% in stocks and 10% in bonds. Similarly, an 80-year old investor would be 40% stocks and 60% bonds. A more conservative approach is the “100-age” formula for stocks. In any case, investment risk typically increases with a higher allocation to stocks, and decreases with a higher allocation to bonds.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Fundamentals of Fixed Income ETFs

A recent Wall Street Journal article nicely summarized the fundamentals that define fixed income ETFs. Understanding these fundamentals can be very helpful in using them in a portfolio seeking the stability of bonds.

Quality, maturity and pricing of Bond ETFs

Two fundamental components that define a fixed income ETF are credit quality and maturity. Remember that fixed income ETFs are a collection of individual bonds. Also, a bond is a loan with fixed payments. That is why bonds are often referred to as “fixed income” investments. Credit rating firms, like Moody’s or Standard & Poor’s, evaluate the riskiness of the loans. Maturity measures the time until the original loan amount is due.

So, there is a strong relationship between a bond’s yield and these two fundamental components. Generally speaking, when a bond is first created, yields are higher under either (i) a lower credit rating or (ii) longer maturity. Once a bond is issued and makes its way into a bond ETF, the price of the bond ETF can then change. But, the underlying bonds continue to issue a stream of constant payments. The only significant exception occurs when the corporation making the bond payments enters bankruptcy protection.

Consequently, prices tend to decrease when demand is low, and investors prefer riskier assets. Conversely, prices of fixed income ETFs generally go up when investors seek less risky assets.  Yields are then inversely related to bond prices, so higher prices lead to lower yields.

What else can affect a bond’s price?

Interest rates can also affect bond prices. Short term rates set by the federal funds rate appear in the image below. As this chart shows, short term rates continue to climb steadily. But, these rates remain below typical levels seen in the past 20 years.

Federal funds rate for the past 20 years.
Federal funds rate for the past 20 years.

So, are bonds a bad investment as short-term rates go up?

This is an important question with no easy answer. But, few would argue that a diversified portfolio benefits from having some bond investments. So, the question should be “what part of the bond market is most suitable to your goals? ” Given there are bond ETFs covering a wide range of maturities and riskiness, there is no shortage of fixed income ETFs for investors to pick from. To this end, we encourage you to subscribe to ETFMathGuy to see how we use a wide variety of commission-free bond ETFs in efficient portfolios.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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July 2019 optimal portfolios are now available and discussed in terms of recent and long-term market trends

The July 2019 optimal portfolios are now available to subscribers of ETFMathGuy. So, please log in and select your discount broker. In this post, we will also discuss more about risk and return in an optimal ETF portfolio.

As we mentioned in our last post, there are benefits to having more ETFs to choose from during the portfolio construction process. We showed the potential to increase expected returns. In this post, we highlight another important element – risk.

Risk and Return

Risk and return are two fundamental issue that are important to consider when investing in an ETF portfolio. The chart below shows risk (horizontal axis) and return (vertical axis). Here, we define risk as the annual volatility, measured by the standard deviation of daily returns. We evaluate risk and return using a multi-year sample period selected from our rigorous backtesting process. As this chart shows, the optimal portfolios reside at risk levels between the bond market (ticker: AGG) and stock market (ticker:IVV). And, these portfolios are efficient, since they were selected to maximize the expected return.

Risk (Volatility) and Expected Return in the July 2019 optimal portfolios. Notice that at each risk level (conservative, moderate and aggressive), different ETFs offered by different discount brokers leads to different expected returns.
Risk (Volatility) and Expected Return in the July 2019 optimal portfolios. Notice that at each risk level (conservative, moderate and aggressive), different ETFs offered by different discount brokers leads to different expected returns.

As this chart shows, cash can be nearly risk-less, based on volatility, but offers returns that may not exceed long-term inflation. Bonds can offer more of a potential return, but with added risk. Even more return is possible from the stock market for those willing to accept additional risk.

What about the last 6 months?

Indeed, it is true that the first half of 2019 has been very good for both stocks and bonds. Based on a recent Wall Street Journal article, “… S&P 500 finished Friday up 17% this year, marking its best first half since 1997 “. According to the site ETFreplay.com, and including dividends, the stock and bond market are up 18.3% and 5.8%, respectively, this year. Will this trend continue? I personally doubt anyone really knows, as I believe that markets are generally very efficient. A better question may be “What level of risk” or “How much exposure” do you want your investments to have in various parts of the market. To end this post, I’ll leave you with one (of many) famous quotes by Warren Biuffet.

“The stock market is a device to transfer money from the impatient to the patient.”

Warren Buffett

We hope you found this post educational!

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Opportunities from more commission-free ETFs

Earlier this month, Fidelity followed through on its promise made earlier in the year. They now offers over 500 commission-free ETFs. This increase puts them in 2nd place for most commission-free ETFs offered by the five discount brokers analyzed each month by ETFMathGuy. The leader is still Vanguard, with approximately 1,800. Our chart below shows the update for Fidelity’s offering, where the Vanguard count only represents Vanguard ETFs. (We will be updating our Vanguard database soon.)

Vanguard* count only includes Vanguard ETFs. Vanguard now offers approximately 1,800 ETFs commission-free.
Vanguard* count only includes Vanguard ETFs. Vanguard now offers approximately 1,800 ETFs commission-free.

What is the benefit of more commission-free ETFs in a portfolio?

The most obvious benefit is the opportunity to access portions of the market not previously available. I demonstrated this benefit in previously published research entitled “ETF trading strategies to enhance client wealth maximization“. Here at ETFMathGuy, we have seen these opportunities first hand in our optimal portfolios. Each month, we’ve developed portfolios based on the current number of ETFs offered by each discount broker. We have also calculated the expected return associated with these portfolios, and there appears to be a potential opportunity. When constructing portfolios with more ETFs available, we see in the figure below that expected returns generally improve. Note that the pair of dots next to the portfolios are the result of excluding commission-free municipal bonds when generating a portfolio suitable for an IRA.

Expected return of ETFMathGuy optimal portfolios tend to rise with more commission-free ETFs available

More commission-fee ETFs may not always be beneficial

This figure shows that having more options to invest can improve the likelihood of generating higher returns. But, the additional ETFs must be sufficiently different those that are already offered. They must also have the potential to generate higher returns. Ameritrade seems to be accomplishing the most with their approximately 300 ETFs. Conversely, ETrade offers many more ETFs than the 59 offered by Vanguard, but doesn’t appear to increase expected returns by much in the portfolios constructed by ETFMathGuy .

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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June 2019 Optimal Portfolios are Now Available to ETFMathGuy subscribers

The June 2019 optimal portfolios are now available to subscribers of ETFMathGuy. So, just log in and select your discount broker.

You can now view the June 2019 optimal portfolios for the five discount brokers analyzed by ETFMathGuy. These portfolios cover nearly 1,500 ETFs currently offered commission-free from Ameritrade, ETrade, Fidelity, Schwab and Vanguard.

In all cases, we applied our rigorous portfolio construction process to produce the current portfolios. So, we encourage you to browse through these portfolios to review the following characteristics:

  • Allocation of bond versus stock ETFs in the optimal portfolio
  • Turnover from the previous month or months
  • The effect of risk level on the overall portfolio risk statistics
  • The increase in expected return as risk level increases

We hope you find these portfolios educational!

Where are the ESG funds in the 2019 optimal portfolios?

In our mid-April post, we updated the database used by ETFMathGuy to include the expanded list of commission-free ETFs offered by five discount brokers. We also mentioned one of the most popular themes to hit the ETF landscape, called Environmental, Social and Governance (ESG) investing. For example, Vanguard offers two of these ESG funds.

These two ETFs carry an expense ratio of 0.12% and 0.15%, respectively, consistent with Vanguard’s low-cost philosophy. So, why aren’t these funds appearing in the current portfolios developed by ETFMathGuy?

The short answer is that our portfolio construction process requires a sufficient return history. Based on our backtesting results, we identified an optimal sample period of several years. Unfortunately, the two Vanguard ETFs noted above have only existed since September 18, 2018, or about the last 8 and a half months. Consequently, this history is simply too short for our optimization model to generate portfolios that satisfy investor return expectations.

So, is ESG investing worthwhile?

This is an excellent question! In fact, based on a recent Wall Street Journal article, other experts in the industry shared our concern about a short return history.

“Many of these ESG ETFs are relatively young and have not had a chance to prove if they can demonstrate strong performance”

Todd Rosenbluth, senior director of ETF and mutual-fund research at CFRA

What does this mean for you? Well, if you are an investor focused on using your beliefs to guide your investment decisions, you may find this short history acceptable. However, here at ETFMathGuy, we prefer to make evidence-based decisions. So, we look forward to analyzing longer return histories that may show how ESG funds could be part of an optimal portfolio.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios. June 2019 optimal portfolios are now available.
ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Using diversification to deal with market volatility

A recent Wall Street Journal article discussed the behavioral aspects caused by market volatility. The article nicely summarizes the long term view of the market. Based on historical analysis, there is a 2% drop in the stock market every 33 trading days, on average. With the Dow at its current levels, that is a 520 point drop every 6 weeks or so.

If this amount of volatility is “keeping you up at night”, perhaps your portfolio isn’t properly diversified? I touched on diversification using bonds in my last post, and will discuss diversification more broadly now.

So, what is diversification?

Simply put, diversification is not allowing for concentrated positions in a portfolio. For example, if you have a portfolio of a single stock, this portfolio is not diversified. But, as more stock is added from different companies in different sectors, investors can often reduce portfolio risk. However, market risk remains, as shown below.

Increasing the number of stocks reduces risk, as measured by the standard deviations of periodic returns.
Increasing the number of stocks reduces risk, as measured by the standard deviations of periodic returns.

Going beyond market risk for wider diversification and reduced volatility

A simple approach to managing portfolio risk is through mutual funds or exchange traded funds. Both investment vehicles hold a basket of many securities, eliminating the need to hold individual stocks to properly diversify. Here at ETFMathGuy, we are advocates of ETFs (exchanged traded funds), because ETFs have better tax efficiency, (usually) lower expense ratios, and often trade commission-free.

Now, most individuals also invest outside the stock market. So, they seek diversification by investing in other asset classes too. For instance, bonds tend to “zig” when stocks “zag”. To see an example of this approach, consider the conservative Fidelity optimal portfolio by ETFMathGuy published for March 2019, and shown below.

Taxable portfolio using Fidelity commission-free ETFs reduces volatility

Assuming an investor buys-and-holds this portfolio from March 4, 2019 through May 21, 2019, the growth of $100 appears below. Notice that the large drop at the end of this time period. This volatility, shown in blue as the S&P 500 ETF (ticker: IVV), is largely unnoticeable in the ETFMathGuy optimal portfolio, shown in green.

Comparing volatility of the conservative ETFMathGuy optimal Fidelity portfolio to the S&P 500 ETF
Comparing volatility of the conservative ETFMathGuy optimal Fidelity portfolio to the S&P 500 ETF

Digging into the statistics reveals compelling information about the volatility. The annualized volatility over this period of the ETFMathGuy portfolio is 4.0% versus 11.0% for the S&P 500 ETF. Clearly, diversification across asset classes (like stocks and bonds) can be a very effective way to manage volatility.


ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Risks and Opportunities in Fixed-Income ETFs

Fixed-income ETFs (also known as bond ETFs) continue to grow at a rapid pace. Bond ETFs now exist across a wide spectrum of characteristics. Looking for shorter or longer maturity? Or, how about higher yield (aka junk bonds) versus investment grade or Treasury bonds? ETFs even cover the bond markets in both emerging and developed economies worldwide.

At this rate, State Street Global Advisers predicts that assets in bond ETFs could reach $1 trillion by the end of 2019.

What is driving demand?

Like stock-based ETFs, low cost is a big driver. Greater tax efficiency, as we discussed in detail in a post earlier this year, over bond mutual funds helps too. But, the biggest demand could be simply choice.

“Investors really have a lot of choices — more than they’ve had in the past five years. “

Noel Archard, State Street Global Advisors

Liquidity concerns?

Our opinion at ETFMathGuy is that liquidity concerns are minimal. In fact, real-time ETF price availability helps the price discovery process, and should improve liquidity.

“Fixed-income ETFs have been tested more than once over the past 10-11 years, without any major issues. “

Rich Powers, Vanguard

The current focus of fixed-income ETFs

The current focus of fixed-income ETFs is now in portfolio construction. Here at ETFMathGuy, we are helping to lead this initiative by building portfolios to take full advantage of what fixed-income ETFs have to offer. For instance, in the May taxable conservative portfolio for Vanguard, we show a portfolio with a a variety of fixed-income ETFs in it. We also seek to include higher volume alternative ETFs, to mitigate any possible liquidity issues and minimize the bid-ask spread trading costs.

May 2019 taxable optimal portfolio for risk conservative investors, by ETFMathGuy.
May 2019 taxable optimal portfolio for risk conservative investors, by ETFMathGuy

In conclusion, fixed-income ETFs are in important core component of an optimally diversified portfolio. We invite you to browse through the current month optimal portfolios to see the importance of bond ETFs.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.
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Zero and negative expense ratio ETFs have arrived.

In the past few months, firms have begun to offer zero expense ratio and negative expense ratio ETFs. In an article recently published by the Financial Adviser, two
zero expense ratio ETFs were mentioned. The first were the Sofi Select 500 ETF (ticker: SFY) and the SoFi Net 500 (ticker: SFYX) . Both have temporarily waived fees until at least June 30, 2020.

Then, Salt Financial filed for an ETF with the Security and Exchange commission, named the Salt Low TruBeta US Market ETF, with a -0.05% expense ratio. That’s right…this fund will pay investors $5/year for every $10,000 invested. Similar to the Sofi ETFs, this offer is good until April 30, 2020, or when the fund reaches $100M in assets under management.

So, do these expenses justify selecting them over other ETFs with similar objectives, but charge a higher rate? A recent survey by Brown Brothers Harriman indicated that for U.S.-based advisers and fund managers, expense ratio was the most important criteria. But, there are other factors worth considering.

Other costs matter beyond expense ratios

As my previous journal article “Is There a Free Lunch in Commission Free ETFs?“, I cited three expenses relevant to ETF investments.

  1. Expense ratios
  2. Trading commissions
  3. Bid-ask spreads

The SoFi Select 500 ETF is easy to compare to other ETFs that track the S&P 500 Index. The table below shows its expenses versus ETFs with similar objectives, and offered commission-free from one of the five discount brokers analyzed by ETFMathGuy.

Individual and Total Expenses for S&P 500 ETFs, assuming $10,000 investment over 1-year.
Individual and Total Expenses for S&P 500 ETFs, assuming $10,000 investment over 1-year.

As this table shows, a prudent investor would recognize that the SoFi ETF average bid-ask spread makes it an inefficient way to invest in the S&P 500.

What about the other ETFs with zero and negative expense ratios?

Evaluating the other securities is more difficult, due to their limited return history. After a longer history is available, the returns of these funds could be compared to other ETFs. Then, we could form a table like the one above with ETFs that have a nearly perfect correlation to these funds. Assuming these firms avoid closing these funds, we plan to look at this topic in the future.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.

ETFMathGuy is a subscription-based education service for investors interested in using commission-free ETFs in efficient portfolios.