One of the problems with actively managed mutual funds is that you can never be sure that the risk level will remain constant. In an income fund with a mix of government bonds, high-yield corporate bonds and dividend-paying stocks, for example, the exposure to these asset classes can vary according to the manager’s whims. Well, it turns out that same is true of some ETFs.
The iShares Diversified Monthly Income Fund (XTR) uses several other iShares ETFs to offer a blend of “income-bearing asset classes, including, but not limited to, common equities, fixed income securities and real estate investment trusts.” The fund’s web page makes it clear that “BlackRock Canada will review, and may adjust, XTR’s strategic asset allocation from time to time, as market conditions change.” However, in practice, the fund’s asset mix has remained virtually unchanged since its launch in August 2010.
But not anymore. XTR recently made a big shift that has significantly changed its risk profile (hat tip to reader Alec P. for pointing this out). Here’s how the fund’s holdings have changed:
Holding | Feb 29 | March 22 |
iShares S&P/TSX 60 (XIU) | 15.0% | – |
iShares DJ Canada Select Dividend (XDV) | 14.6% | 5.0% |
iShares S&P/TSX Equity Income (XEI) | – | 10.0% |
iShares S&P/TSX Capped REIT (XRE) | 14.5% | 8.6% |
iShares S&P/TSX Capped Utilities (XUT) | – | 9.9% |
iShares S&P/TSX North American Prefs (XPF) | 11.8% | 6.1% |
iShares US High Yield Bond (XHY) | 9.1% | 17.0% |
iShares DEX HYBrid Bond (XHB) | 8.9% | 20.2% |
iShares DEX All Corporate Bond (XCB) | 8.8% | 20.1% |
iShares DEX Long Term Bond (XLB) | 8.7% | 3.0% |
iShares DEX All Government Bond (XGB) | 8.6% | – |
Canadian bonds | 35.0% | 43.3% |
US bonds | 9.1% | 17.0% |
Canadian equities | 29.6% | 24.9% |
REITs | 14.5% | 8.6% |
Preferred stocks | 11.8% | 6.1% |
A major shift
The biggest change is a doubling of the exposure to high-yield bonds (via XHY and XHB), from 18% to more than 37%. The allocation to government bonds, meanwhile, has fallen from more than 17% to just 3%. The fixed income side of the portfolio is clearly a lot riskier than it had been for the last 18 months or so.
The greater allocation to high-yield bonds is offset somewhat by the lower allocation to equities, which has fallen from over 55% to less than 40%. By dropping XIU (which has about 34% in banks and less than 1% in utilities) and adding a 10% allocation to XUT, the portfolio now has a dramatically different mix of sectors, too. Reducing the holding of XDV (55% financials) and adding XEI (31% financials) also reflects a move away from the big banks.
All of this highlights the problem with investing in ETFs that do not track an index. Granted, XTR’s asset mix is not subject to the whims of a fund manager and her worthless forecasts: it’s based on a series of quantitative screens “designed to identify and optimally diversify portfolio exposure” within prescribed limits. But this is still tactical asset allocation, a strategy commonly employed by active managers, and one that is of dubious value to investors.
XTR isn’t the only fund that makes tactical shifts according to market conditions: the iShares Core Portfolio Builders and Claymore CorePortfolios also do so. While these “ETFs of ETFs” offer one-stop diversification at low cost, investors need to check in once per quarter to make sure they are still comfortable with the risk levels. Or, better yet, consider building your own ETF portfolio using a long-term asset allocation that doesn’t rely on guesswork.
Wow. I followed your link to XCR iShared Conservative Core Portfolio Builder Fund and read, “The fund may also employ currency hedging.” But then again it may not!
I was looking at XTR not long ago. I *think* I like the new weightings better. As this is an ETF of ETFs I’m assuming there is more upside to the market price as well, and better positioned for rising interest rates (less govt & long bonds, REITS and preferred)?
Thoughts?
@Reggie: This is just active management based on market forecasts, which is one of the things the Couch Potato strategy is designed to avoid. People stayed away from long-term bonds in 2010 and 2011 because of fear of rising interest rates and they returned 12.1% and 17.7%, respectively.
Thanks for the feedback! Good point.
Thx for sharing this info. I know someone who holds this and would be interested in the change.
Thanks for the post. I have a traditional couch potato portfolio but I looked into XTR and XAL recently because of the track record and its logic.
Over 3 years XTR returned 25.8%, without reinvesting dividends, with a standard deviation of 10.3 and a Sharpe of 2.2. This reflects superior risk adjusted returns.
A portfolio of XIU and XBB in equal weight (which I think is around what XTR was in terms of equity correlation for the past 3 years) returned 11.7% without dividends.
XAL returned 15.4% over 3 years. Is it just luck?
The changes to the portfolio of XTR now seem to be reflecting judgements about certain macro conditions which have already begun to change and are highly likely to continue in the same direction of change namely interest rates rising, inflation rising and equity multiples either staying the same or contracting (with equity profits or earnings peaking on an interim basis – they revert to means over long cycles- there is a lot of research pointing to this I can post if interested).
The manager is lightening up on interest rate sensitive instruments like longer date bonds and REITS and preferreds (except the inclusion of the utility ETF which is very rate sensitive because of high leverage in the industry but it has a very stable cash flow) tilting toward yield with lower duration. The changes also increase credit risk because corporate balance sheets are in good shape with high cash positions generally. It is credit informed tactical asset allocation which has been shown to have excellent risk adjusted returns.
I understand the tenets of couch potato investing but I have trouble arguing with this particular tactical allocation.
I would appreciate any comments about this.
@Andrew: I would refer you to the interview I did with Scott Burns a while back. This is a slippery slope that starts out with, “I understand the tenets of couch potato investing but I have trouble arguing with this particular tactical allocation” and ends with, “I know more than the market and I’m going to keep repositioning my portfolio every six months based on macro forecasts.” One of the pillars of Couch Potato investing is that tactical asset allocation is counterproductive.
https://canadiancouchpotato.com/2012/02/23/scott-burns-interview-part-2/
Thanks Dan for the heads up. I do get the idea of it being a slippery slope. That said it seems this manager is putting a higher probability on the scenario of rising rates and is adjusting accordingly. The alternate two scenarios rates stay the same or go lower are less likely for reasons that have to do with central bank intervention that will end eventually. Also short rates cannot go less than zero, except in niche markets. Bill Gross has had some excellent commentary lately about how zero bound rates distort markets and it is a flag that many TIPs auctions are now at negative rates. A lot of people who have put a lot of money into bond funds in the past several years, particularly the longer duration ones, may be in for quite a sticker shock when they see the value of those “safe” investments go down.
Asset allocation is a function of risk tolerance and a new risk is emerging – that of rising rates – so the manager is tilting toward this higher probability scenario. The newer asset allocation should do better in a rising interest rate environment than the old allocation.
So why is it wrong to change asset allocation given this scenario? The changes do not reflect an all in bet on this scenario (if it did then there would be a very different asset mix) but a tilt toward it being more likely.
Here are several statements which are justified by recent research that change the risk dynamic and so risk tolerance. It is generally understood that asset allocation has to be changed dynamically to account for such things as how long until retirement or how long until say an RESP will be spent.
I have to ask myself if I should be revisiting my asset allocations using metrics other than what I have in the past such as the following statements supported by recent research:
-starting valuation levels of bonds imply future returns from bonds particularly from very low yield bounds – there is a high probability that when 10 year bonds trade below 2% a very long bear market in bonds ensues
– stock and bond correlations can become sometimes very high and very low – that is rise and fall in value together or opposite each other.
– stocks are expensive on the basis of Q and CAPE and these metrics have a better than random record of forecasting future long run returns
– profit margins mean revert – one of the most statistically strong series in finance – stock multiples over long horizons depend much more on profits than multiples – high margins will therefore come down implying lower future real returns from stocks relative to the recent past
– returns are “regime dependant” – there can be long periods of underperformance that is not expected by assuming a random or statistical bell distribution – rebalanced 60/40 has had rolling 10 year holding periods that were negative a quarter of the time since 1901 and negative 1 in 3 years, and worse than -10% 1 in 6 years
– Correlations can rise during high stress times and so diversification benefits can be limited
@Andrew: Thanks for the thoughtful reply. This is a big issue, and I do hope to write something about it in the near future, based on just having read Mebane Faber. The short response is simply that, in my opinion, we need to simply accept that asset allocation models have never been perfect, and that no one should suggest a buy-hold-rebalance strategy to be the winner in all periods. No strategy works in all periods.
The main issue is that humans are generally terrible at sticking to any long-term strategy. I think that a passive strategy with a long-term strategic allocation is probably the easiest to follow because there are very few decisions involved once you have set it up. (And it is certainly the cheapest.) The less you touch it, the better it works.
By contrast, a tactical strategy that involves constantly projecting expected returns based on moving averages, Q, CAPE or whatever, is much, much harder to execute than people think. I can’t argue with Faber’s data, for example, and if you followed his strategy to the letter (and somehow did it for free without incurring taxes), then maybe you could expect better risk-adjusted returns. But how many people do you think can pull that off in the real world? At some point the arguments need to be practical, not theoretical.
As for interest rates being poised to rise, let’s remember that’s been the refrain for three years, and it’s been wrong. Anyone who has sat in short-term bonds or cash for the last three years has paid a very high price for being wrong, and if and when rates eventually rise, they will still have underperformed those who simply stuck to a more balanced fixed income portfolio.
Thanks for the update on xtr. I hold it in one account. that said, I have no problem with the reconfiguration. It looks like they’re chasing yield, given the income mandate.
Was actually thinking of combining xtr (40%) with cbd (40%) and zwb (20%) for a large percentage of my cash that keeps earning less and less in an ING Direct ‘high interest’ savings account.
It looks like xtr and cbd would give you a nice portfolio with decent income, especially if you charge it up with zwb. Portfolio would yield 5%.
Yes I know this portfolio will make Dan cringe… too much active management.
@Dale: I can barely type, I’m cringing so much. :) Seriously, as long as you’re aware that the risk profile of your portfolio bears no resemblance to a savings account, that’s fine. The additional income always comes with a corresponding risk of capital loss.
Hey Dan, thanks. Yes I know it comes with risk on a few fronts from equity to rising interest rates to outright corporate bankruptcy/default rates and more. It’s just over half my cash balance so I’m fine with adding some risk for more income. High Interest savings seems to be dead for now, except for one’s emergency living stash.
There is now risk (in no-risk investments) in this low interest rate, modest to high inflation environment, in that your savings are actually decreasing in purchasing power.
It’s exactly what the governments of North America wanted to do to savers – make them take risk.
Mission accomplished.
@Dale: I agree, cash is not an investment, it’s emergency savings that is pretty much guaranteed to lose against inflation, at least for now. People who want to earn a sustainable income from their investments need to take more risk than they used to. Unfortunately, I think many people are not well equipped to do that. Sounds like you have a good handle on the tradeoff, but some others do not! :)
And I would finish with… it’s possible that by pushing investors in search of higher income, and with the fear of equities for many, governments are continuing to do what they do best… inflate another bubble… this time in bonds.
Dangerous and curious times.
I don’t like these funds-of-funds (like XTR). These products are catering to investors who think they can simply plonk down some amount of capital and reliably generate a target income. e.g. “I’ll invest 400K, and get paid $2,000 every month!” But equities and junky corporates (the underlying) don’t work like that, so it’s all artificial.
The problem is that to keep up this appearance that the fund can provide a stable income, the managers will radically change their instrument & risk exposure. It’s almost inevitable that the managers will reach too far for yield, and eventually the structure will crack, and distributions and/or share price will fall sharply (reflecting losses).
Look at XTR’s distributions: constant $0.06/share every month, for two years now! Do equities and junk corporates pay that regularly? Of course not… the fixed 6 cents is artificially achieved by constantly adjusting the underlying weights, and buffering cashflows internally. This will only work so long as corporate default rates stay low, and dividends aren’t cut. The fact that XTR tries paying a constant distribution is what makes me nervous, because I know they will take on too much risk to keep it up.
I think it’s much smarter to buy ETFs which have known composition. Then you can choose your exposure to, e.g. 50% utilities (ZUT), 30% div stocks, 20% junk bonds.
@Perpetual Bull: As you can tell from the post, I’m not a big fan of these funds either, but I should point out that there shouldn’t be a concern about the fixed distribution. As with virtually all monthly income funds, this is maintained by adding a portion of return of capital (ROC) to the interest and dividends generated by the fund. It’s not “artificially achieved by constantly adjusting” the underlying holdings.
It’s true the fund’s yield of 5.4% is not sustainable indefinitely and many investors don’t understand that, but the managers are not under pressure to keep the NAV constant: they will let it decline gradually. If they are used by retirees who are gradually drawing down their portfolios (including some of the capital), monthly income funds can be quite convenient, and there is no suspect activity going on behind the scenes.
XTR is in my portfolio for more than 2 years and collecting almost 6% return year over year. I like this ETF because of its instant diversification.
I guess investors like the new asserts allocation s because the price is moving up in the recent months.
Best Regards,
I own some of XTR as well and I was aware of the fact they need to mix in ROC to the distributions to keep up with the yield even before I dove in, but….recently the price has gone up, instead of down gradually as I expected. Is this simply because there is net positive influx of buyers, more than enough to compensate for the ROC needed to keep up with the yield? if this is the case, isn’t this almost like a legal Ponzi scheme!?
@smartypants: The price went up simply because the value of the underlying holdings has gone up. As long as the total return on the fund exceeds the distribution yield the fund should not fall in price.