Fund Spotlight

There are many ways to approach asset allocation, but honest evaluation of goals and risk tolerance should paint a broad picture of a portfolio’s priorities. Every investor is an individual with different needs and timelines. While some are focused on preserving retirement income, others seek aggressive yield on returns. The majority require a customized variety of funds to balance security with growth. Categorizing holdings according to larger goals or “buckets” is one way to keep investment goals on track through volatile spells and offers investors a simple investment plan model.

Allocating Assets

When it comes to general asset allocation, most investors start at the top, considering age, risk tolerance and desired return, followed by sector exposure, foreign exposure, risk and yield, to ultimately drill down to a decision about which individual funds to hold. This is a solid approach that works for many people. Rebalancing is straightforward, and portfolio withdrawals are based on a fixed amount or percentage of the portfolio, generally using a systematic rule such as a variant of the hotly debated 4 percent withdrawal rule.

Pension funds take a liability-responsive asset allocation approach, breaking down their investments in terms of liabilities. They pay money to current pensioners, prepare to pay people nearing retirement and plan to pay into the future as necessary. Pension funds take on more risk and hold a large share of equities, so for workers nearing retirement, these funds need to shift into more conservative, income-generating assets. For current pensioners, the pension fund needs to protect the value of the assets it may need to sell to meet its obligations.

Individual investors can take a similar approach when allocating personal assets. An investor’s current liability is money needed in the next few years and should never be placed at risk. More risk can be taken with 10-year assets, but the investor should still use caution in the event of a bear market. Money that won’t be needed for at least 15 years or perhaps is intended for heirs can be more aggressively invested.

The three portfolio segments described above are sometimes referred to as buckets. The first is the cash bucket, the next is the intermediate-term bucket and the last is the long-term bucket. They could also be described as the low-, moderate- and high-risk buckets.

Using this approach, an investor will first consider the cash bucket. Immediate expenses over the next two to five years are allocated here. The money is invested in savings accounts, money market funds, CDs and/or short-term Treasuries. A special account may be designated for these assets.

The next bucket is for money needed over the next 10 years. Instead of cash, an investor might hold intermediate-term bonds, corporate bonds and higher-yielding bonds.

The third bucket contains higher-risk assets such as equity funds. When allocated appropriately, this is the category likely to see the greatest amount of growth, especially when it is carefully monitored and managed.

Benefits

Determining how much income is needed and separating those assets can go a long way toward reducing the emotional impact of volatile markets. Using the bucket approach to allocation can help investors focus on the holdings themselves instead of the overall portfolio return. Watching a portfolio drop 10 percent in a bear market might be nerve-racking for an investor worried about near-term expenses, but the same investor may be able to stomach it better when seeing the portfolio broken down into buckets, with no loss in the cash bucket, a small loss in the second bucket and large losses in the third bucket. Even though the total value will drop the same amount as would a single account, breaking holdings into separate accounts may be a useful tactic if it brings peace of mind.

Costs

While investment buckets can make sense as a way of thinking about your assets, putting a bucket strategy into practice has costs. Assets need to be shifted between buckets (accounts) as time passes. Asset rebalancing is complicated by the need to shift assets across accounts. Maintaining discipline is the key to successfully implementing the bucket strategy.

Furthermore, cash withdrawals are easier to manage in a single account. A single account can be rebalanced without having to transfer assets, which may be impossible if some assets are in tax-deferred accounts. Many investors have multiple accounts – perhaps a savings account, a brokerage or fund account, a traditional IRA, and a Roth IRA. Managing three buckets across four or five accounts can become unwieldy over time.

The biggest cost for investors may be the complexity, including maintaining a balance between the accounts over time and preparing for surprises. If you have an emergency and need extra cash, from which bucket do you sell assets? Are you constantly depleting your cash bucket, or is it more of an emergency reserve that is seldom tapped? Many investors already use something akin to the bucket approach with their accounts due to tax efficiency. An IRA can’t be tapped penalty-free until retirement, and a Roth IRA has no required minimum distributions. In light of this advantage, some investors place long-term assets into their Roth, since they are least likely to be sold. Some investors prefer to place high-yielding and tax-inefficient mutual funds in their tax-deferred accounts to lower their tax bill, while holding long-term, tax-efficient equity funds such as ETFs in their taxable accounts. Breaking the portfolio into buckets adds another layer of complexity to these considerations.

Conclusion

Breaking your portfolio into buckets is a simple allocation approach. It aligns risk with time, with your shortest-term capital in the lowest-risk assets and your long-term capital in the highest-risk assets. You may find your portfolio has too much risk and not enough cash, but you may also discover you’re worried about assets you don’t plan on touching for 15 years or more. Managing your money in buckets may be taking the next step, but it is a much larger step and one that requires diligent planning. For more information about our investment strategies, call us at (888) 252-5372.

Market-cap weighted indexes dominate the ETF realm. Funds such as SPDR S&P 500 (SPY) attract investors by allocating assets according to a company’s market value. This eliminates the need for rebalancing and keeps costs low. Only when a company is added or removed from the index is rebalancing necessary, resulting in a very low-cost strategy that enables many large fund providers to offer large-cap market-weighted funds for less than 0.10 percent in annual management fees.

There are some drawbacks to market capitalization weighting as well. Weighting by market cap leads investors to own the most overvalued stocks in an index, and these stocks are hit hardest in the event of a correction or bear market.

Fund companies have created many alternative strategies to meet investor demand, ranging from simple to highly complex. Among the simplest funds are those that take the S&P 500 Index, or a substantially similar universe of stocks, and tweak the weighting methodology. WisdomTree Large Cap Dividend (DLN) uses dividends to weight holdings, while SPDR S&P Dividend (SDY) uses yield. Oppenheimer Large Cap Revenue (RWL; formerly RevenueShares) takes the S&P 500 and weights component companies by revenue. WisdomTree Earnings 500 (EPS) ranks companies by earnings. Guggenheim S&P 500 Equal Weight (RSP) fund utilizes the S&P 500 Index to weight holdings equally.

Sector and Market Cap Exposure

Two of the key factors affecting these alternative funds are their sector exposure and average market cap. Sector exposure can change over time, but most of these indexes tend to be relatively consistent. It’s a safe bet that five years from now the dividend-weighted funds will still be overweight utilities as compared with the S&P 500 Index.

As for specific sector exposure in each fund, with SPY for comparison: SPDR S&P 500 (SPY) counts technology, financials, healthcare, consumer discretionary and consumer staples as its top five holdings, with weightings ranging from 20.4 percent down to 10.5 percent in this group.

Guggenheim S&P 500 Equal Weight (RSP) weights financials at 17 percent of assets. Industrials are in the top five, while consumer staples are removed. RSP has more assets in utilities and materials, but not to a significant degree.

SPDR S&P Dividend (SDY) has 22.8 percent of assets in financials, followed by 16.3 percent in industrials, 14.5 percent in utilities, 12.3 percent in consumer staples and 10.6 percent in materials. Technology and healthcare are significantly underweight. Utilities is the major standout, and the fund tends to perform strongest, relative to the S&P 500 Index, when markets are underperforming.

WisdomTree Large Cap Dividend (DLN) is the most balanced of these funds, with only 15.4 percent in its largest sector, consumer staples. The fund does have 11 percent in energy, making it the most highly exposed of the group. Since the fund is balanced, the impact isn’t too pronounced, but DLN does tend to out- and underperform alongside the energy sector.

WisdomTree Earnings 500 (EPS) is the most similar to SPY in terms of sector weightings. Financials are 21.3 percent of assets, but technology is close behind at 19.3 percent.

Oppenheimer Large Cap Revenue (RWL) has 21.3 percent of assets in consumer discretionary and 20.6 percent in consumer staples, currently heavily weighted in consumer sectors. Since RWL uses revenue to weight holdings, however, weightings can change substantially over time, sometimes in as little as one year. Financials tumbled in 2008, as did energy firms in 2015.

Market-cap exposure is important in both the short and the long term. The equally weighted RSP is barely within Morningstar’s Large-Cap Blend category and almost falls into the mid-cap category as every holding in the fund gets a 0.20 percent weighting. SPY devotes more assets to larger companies given its strategy of market-cap weighting. It has 3.2 percent of assets in Apple (AAPL), 16 times the weighting of AAPL in RSP. As a result, SPY almost falls in the Mega-Cap Blend category. DLN, SDY and RWL all fall in the Large-Cap Value category, but SDY leans toward mid-caps. EPS is the most similar to SPY, falling in the Large-Cap Blend category.

Performance

Long-Term Performance since 2009

Since the market bottomed in March 2009, SPY went on to gain 225 percent through the end of February 2016. All but one alternative fund discussed here outperformed: EPS, which gained only 214 percent. The other funds ranged from a low of 229 percent for DLN to a high of 291 percent for RSP.

Performance in 2015

Last year was tough for value stocks and mid-caps. All five alternatives were beaten by SPY, which gained 0.2 percent. Losses ranged from 3.6 percent for RWL up to a loss of 1.9 percent for SDY.

Performance in 2016

In the first two months of 2016, SPY lost 5.06 percent. All but one of the five alternatives beat it: EPS fell 5.38 percent. RWL was the worst outperformer, down 4.72 percent, while SDY gained 1.07 percent and was the only fund in the black.

Owing to its lower average market capitalization, RSP behaves more like a mid-cap fund relative to the S&P 500 Index. Investors who expect mid-caps to outperform should consider RSP as an alternative to SPY.

DLN was hurt by energy exposure over the past 18 months, while SDY was significantly impacted by the utilities sector. Only EPS fails the performance test.

Income

DLN’s 2.88 percent yield is the most attractive to income investors. SDY yields 2.51 percent, while the S&P 500 Index presently yields 2.06 percent. The other three funds yield less than 2 percent.

Volatility

Volatility is an important consideration. A less volatile portfolio offers peace of mind and can increase long-term returns if a portfolio sees periodic withdrawals.

SPY has a beta of 1.00 versus the S&P 500 Index and a standard deviation of 10.93. RSP has a beta of 1.00 and a standard deviation of 11.17, and SDY has a beta of 0.86 and a standard deviation of 10.43. RSP is less volatile than SPY and, of the five funds discussed, the least correlated with SPY. DLN has a beta of 0.91 and a standard deviation of 10.28. RWL has a beta of 0.99 and a standard deviation of 11.06. EPS has a beta of 1.02 and a standard deviation of 11.22, the most volatile of the five.

Expenses

At 0.09 percent, SPY is one of the cheapest ETFs in the market. SDY’s 0.35 percent charge is much heftier, while DLN and EPS hold expenses lower at 0.28 percent. RSP charges 0.40 percent and RWL charges 0.49 percent as both require considerable rebalancing each quarter.

Conclusion

Of the five alternatives covered in this article, three are worth considering: RSP, SDY and DLN. Although the approach used by RWL is compelling, its higher fees, lower yield and relatively low average volume make it unattractive. EPS performed poorly and has a lower yield than SPY, and volume is much too low to make it a viable option.

Existing holdings should be taken into consideration when assessing the suitability of each fund to individual portfolios. RSP may balance portfolios with less exposure to mid- and small-caps. For those with hefty mid- and small-cap exposure, one of the large-cap options is more appropriate.

SDY is heavily influenced by utilities. Investors already tapping the utilities sector as a defensive or income holding may want to pass on SDY, depending on the level of exposure. However, it isn’t excessively overweight utilities, with financials and industrials leading exposure.

DLN has relatively high energy exposure, which has been a burden over the past 18 months. Investors who prefer higher dividends and who don’t mind a potentially extended period of underperformance should energy retest or break its lows can opt for DLN.

High-yield bonds came under selling pressure in 2015 as investors reacted to looming Federal Reserve rate hikes and weak oil prices. Shale oil producers borrowed heavily over the past six years, fueling expansion with ultra-low interest rates under the Fed’s quantitative easing policies. Investors grew concerned about energy exposure, and selling pressure spread across the high-yield space, leading to losses in the illiquid portions of the bond market. Fund managers have adapted to changing conditions, finding value in sectors carried lower by the indiscriminate selling seen over the past few months.

 The three-star Morningstar rated Fidelity High Income Fund (SPHIX) seeks high income and capital growth. In addition to small preferred-stock exposure and convertible securities, the fund invests in a range of lower quality, income-producing debt securities. It may also invest in non-income-producing financial instruments, such as defaulted securities and common stocks. The fund typically focuses on securities issued by both domestic and foreign companies facing a troubled or uncertain financial future.

 Investment Strategy

 Under the direction of lead manager Fred Hoff since 2000, SPHIX has followed a strategy of investing in high-yield, non-investment-grade bonds issued by companies that have generally strong balance sheets and that offer the best values within their capital structure. Using fundamental credit analysis, he strives to identify attractive risk/reward characteristics with the assistance of Fidelity’s global research and high-income teams. The goal is to find highly leveraged companies that can provide consistent risk-adjusted returns over a full credit cycle. As a result, he takes a long-term investment outlook with a keen eye on where the market sits within the current credit cycle.

 With over 15 years of experience, Hoff has transformed SPHIX into a moderate-risk offering compared with benchmark Bank of America Merrill Lynch U.S. High-Yield Master II Constrained Index. Hoff focuses on B-rated debt issued by companies that are poised to improve credit profiles within the next few years. Unlike his more aggressive competitors, Hoff does not hold large stakes in common stock, preferring bank loans and cash for remaining assets. He keeps these holdings as low as possible, with the belief that security selection is key to overall performance. Hoff will take risks only when he feels they are warranted.

 Portfolio Composition and Holdings

 Founded in 1990, the fund has slightly less than $4.0 billion in assets under management (AUM). At the end of January 2016, SPHIX had an 86 percent exposure to corporate bonds as well as an 8 percent investment in bank debt and 5 percent in cash and cash equivalents. The fund also has a small exposure to convertible bonds, convertible preferred stocks and equities. Bonds from domestic issuers account for slightly more than 78 percent of holdings. Foreign securities total slightly less than 22 percent of the portfolio. Foreign exposure is derived primarily from Canada, the UK and developed Europe. The fund is diversified; top-10 holdings account for 11 percent of assets. These include bonds issued by CHS/CMTY Healthcare, Tenet Healthcare, Altice and Post Holdings followed by two separate issues from Laureate Education, Citigroup, Hockey MGR, Tronox Financial and the C&S Group.

 The fund’s portfolio is overweight healthcare, banks and thrifts, food and beverage, and services categories. It is underweight energy, diversified financial services and cable TV as well as technology and home building. The portfolio is overweight B- and below B-rated securities and underweight BB-rated issues compared with the category average. The fund has an average weighted maturity of 6.0 years, with an effective duration of 3.69 years. SPHIX has an average credit quality of B and an average weighted coupon of 6.49 percent.

 Historical Performance and Risk

 Hoff showed remarkable acumen steering SPHIX through the hardest-hit areas of the 2008 credit crisis and its aftermath. It was one of only a handful of funds to beat the category averages in 2008 and 2009. Recent performance has been muted by a concentration in B-rated securities. As the market swings from risk-aversion to risk-taking, the mid-level quality tier has underperformed. The fund has recently produced negative low single-digit returns and has modestly lagged the benchmark index. In general, the fund has bolstered its long-term performance by maintaining limited exposure overall to struggling coal and energy names. The fund’s performance was helped by holdings in the steel industry along with picks in the financial sector, including Barclays and Altice Financial.

 SPHIX has delivered 1-, 3- and 5-year total returns of -5.40 percent, 0.82 percent and 4.01 percent, respectively, as of February 2, 2016. These compare with the benchmark returns over the same periods of -4.61 percent, 1.65 percent and 4.84 percent. SPHIX has a 30-day SEC yield of 7.91 percent. The fund has an average Morningstar risk rating. Its 3-year beta and standard deviations are 1.01 and 5.50, which compare with the category averages of 0.58 and 2.96.

 Fees, Expenses and Distributions

 The fund boasts a 0.72 percent expense ratio, compared with the no-load high-yield category average of 0.86 percent. SPHIX has an initial investment minimum of $2,500 for taxable and nontaxable accounts. There is no subsequent investment minimum. The fund has a 1 percent redemption fee for shares held 90 days or less.

Outlook

 At the end of 2015, the high-yield market faced severe headwinds from several quarters. These included a slowdown in China, increasing macroeconomic and geopolitical risks, plunging energy prices that raised the risk of defaults, and a slowdown in emerging market economies. Many of these scenarios have now been priced into the market. This has created a situation where valuations have once again become attractive. SPHIX remains overweight single-B-rated issues as a hedge against volatility.

 A turnaround in overseas economies or a rebound in the oil and gas space could produce a strong rally for high-yield bonds. SPHIX is appropriate for individuals looking for above-average current income and the potential for long-term capital appreciation who can also withstand the additional risk and volatility of the high-yield market. We currently recommend SPHIX as a Strong Buy with a rank of 89.

Fixed income investments offer income, diversification and stability, playing a crucial role in many individual portfolios. Conservative and retired investors should allocate at least a portion of long-term savings in fixed income securities. Bonds, especially government-issued securities, are seen as a safe haven during volatile periods when investors behave more emotionally than rationally and may move inversely with stocks.

AGG has over $30 billion in assets, which has attracted competition. The latest offering aiming for a slice of AGG’s market is WisdomTree’s Barclays U.S. Aggregate Bond Enhanced Yield Fund (AGGY). This new addition to the ETF space is an interesting option that warrants comparison to its larger, more established competitor.

iShares Core U.S. Aggregate Bond (AGG)

A popular investment choice for bond exposure is the three-star Morningstar-rated iShares Core U.S. Aggregate Bond (AGG). This single ETF provides low-cost, broadly diversified exposure to the U.S. investment-grade bond market. As of January 2016, AGG had $31.7 billion in assets under management. The fund seeks to track the performance results of the Barclays U.S. Aggregate Bond Index, which includes U.S. Treasury bonds, government-related bonds and mortgage-backed securities as well as corporate bonds, asset-backed securities and commercial mortgage-backed securities. This index is widely accepted as the benchmark for the U.S. investment-grade bond market, and many “total” or “aggregate” bond funds use it as their benchmark.

AGG invests 90 percent of its assets in bonds contained within the underlying index; however, it utilizes a sampling strategy to engage and considers transaction costs and tax efficiencies when attempting to closely replicate the performance of the underlying index. While the benchmark contains approximately 10,000 individual bonds, AGG holds only 5,000. The fund rebalances monthly and currently is slightly overweight U.S. Treasuries and Agency debt.

The fund spreads its holdings across a broad spectrum of maturities, resulting in an average weighted maturity of 7.3 years. It has an effective duration of 5.1 years. If interest rates either rise or fall by 1 percent, the price of AGG would be expected to deviate by about 5.1 percent. As a result, AGG has a fairly moderate inflation risk. AGG has an average credit quality of AA and an average weighted coupon of 3.23 percent.

AGG has tracked the performance of its benchmark closely, while charging only 0.08 percent, which includes a 0.01 percent expense waiver that expires in June 2016. Over the trailing three-, five-[ALDM1]  and ten-year periods, AGG has trailed the performance of the index by 0.04, 0.10 and 0.16 percent, respectively, which confirms that the fund’s expense ratio accounts for most of the tracking error.

WisdomTree Barclays U.S. Aggregate Bond Enhanced Yield Fund (AGGY)

Many investors are concerned about rising interest rates and inflation, which could impact investment yields. Investors have relied on core bond holdings to mitigate volatility and generate income, but U.S. Treasuries hover near historic low yields. High-yield funds face added risk and volatility. As a result of falling yields, the income generated by AGG has fallen as well. WisdomTree is looking to attract those income-oriented investors looking for additional yield with the WisdomTree Barclays U.S. Aggregate Bond Enhanced Yield Fund (AGGY).

This relatively new fund, established in July 2015, provides the potential for enhanced income while continuing to benefit from a single low-cost option that offers broad diversification. AGGY tracks the Barclays U.S. Aggregate Enhanced Yield Index, which tweaks the Aggregate Index followed by AGG. Utilizing a rules-based approach, AGGY shifts exposure across levels of interest rate and credit risks as well as across various market sectors to increase yields.

Given current conditions, AGGY will typically overweight corporate credit while underweighting Treasuries. The fund’s relative position in mortgage-backed securities may fluctuate given market conditions. This is the opposite of AGG, which tends to consistently invest heavily in Treasuries and mortgage-backed securities due to their relatively large share of the total bond market. The result is a declining yield for AGG but a higher return for AGGY.

The Enhanced Yield Index retains the broad risk characteristics of AGG while reassembling the index’s 20 subcomponents, which reflect a combination of bond types, credit quality and maturity. The index will reallocate assets within and across these subcategories in order to deliver a higher yield.

There are some limits on the ability of AGGY to increase yield. The duration of AGGY cannot be more than one year longer than that of the AGG index. The relative weights of the various subcategories will not deviate more than 20 percent from similar subcategories contained in the comparable AGG. The fund is rebalanced by a maximum of 5 percent each month to ensure that it stays within these risk constraints. If necessary, the turnover percentage will increase by 1 percent increments until the correct weightings are achieved.

The result is a substantially different portfolio in terms of the subcomponents. Recently, AGGY held 18 percent of assets in U.S. Treasury bonds, versus 39 percent in AGG. Corporate bonds were 46 percent of assets, compared with about 24 percent in AGG. These two divergences were the main difference between the two funds and resulted in a distribution yield of about 2.9 percent for AGGY versus 2.5 percent for AGG, or a 16 percent improvement. The gap has been wider at times. As of the end of December 2015, AGGY delivered an additional 79 basis points of yield compared with AGG.

While holding fewer Treasuries in AGGY helped boost its yield, the fund’s smaller Treasury bond position caused it to underperform slightly during the Treasury rally these past couple of months. As of February 15, AGGY gained 1.41 percent in 2016 versus AGG’s 1.59 percent.

AGGY is designed to deliver higher income, not beat the market in all conditions. Investors seeking total return may want to seek out a bond fund that has capital appreciation as one of its mandates. Additionally, , at 0.12 percent of assets, AGGY costs slightly more than AGG. If the strategy delivers over the long term, the increased yield will more than offset the increased fees. This is a hefty risk, however, given the short period of time the fund has been in existence. We are intrigued by AGGY, but nevertheless we shall await a more complete track record. Currently, we have issued a Buy recommendation for AGG and a Hold recommendation for AGGY. This could quickly change as we review relative performance over the coming months.

The Standard & Poor’s 500 Index declined 5.07 percent in January, and the tech-heavy Nasdaq is fairing even worse with a loss of 14.45 percent as of February 10. The integrity of global bank balance sheets, interest rate uncertainty, China’s slowdown and tumbling oil prices have unsettled investors. While the overall market has been under selling pressure, the Vanguard Utilities ETF (VPU) and the company’s Telecommunication Services ETF (VOX) have defied the downward trend: VPU has risen 7.12 percent, and VOX has rallied over the past month and is currently down only 2.31 percent. This month we look at the viability of these two funds.

Vanguard Utilities ETF

Utilities deliver stable cash flows and attractive yields that can mimic the protection of bonds. Vanguard Utilities ETF (VPU) is an appealing low-cost option for income investors seeking broad exposure to U.S. utility companies. This four-star Morningstar-rated fund uses a market-cap weighting strategy; larger firms held within the portfolio have more influence over performance. VPU will generate better returns when large- and mid-cap names are outperforming. Large caps are handily beating small caps in 2016, which benefits VPU.

The portfolio is designed to track the MSCI US Investable Market Utilities 25/50 Index. The fund has 82 individual holdings, with an average market cap of $14.6 billion. The benchmark average is slightly more than $17 billion. VPU has a 54 percent exposure to large-cap stocks as well as a 35 percent allocation to mid-caps and an 11 percent small-cap allotment. While the price-to-book ratio is 1.58, the price-to-earnings ratio is 16.22. The top five holdings, Duke Energy (DUK), NextEra Energy (NEE), Southern Co (SO), Dominion Resources (D) and American Electric Power (AEP), make up 48 percent of assets. These are followed by PG&E (PCG), Exelon (EXC), PPL Corp (PPL), Sempra Energy (SRE) and Public Service Enterprise Group (PEG).

Utilities were regarded as reliable, income-generating stocks prior to deregulation in 2000 and a long interest rate decline. The sector was a strong performer for a time in the 2000s, but in recent years it has suffered with the anticipation of rising interest rates. The recent modification in rate expectations has benefited the sector greatly. VPU has 1-, 3- and 5-year total returns of 4.36 percent, 12.10 percent and 11.96 percent, respectively, compared with the category averages over the same periods of -4.83 percent, 11.56 percent and 10.96 percent. Over the past 10 years, VPU’s standard deviation of 13.6 is lower than the S&P 500 rating of 15.1 percent, but over the past three years it has been more volatile due to swings in rate expectations.

VPU has a 0.1 percent expense ratio compared with the category average of 1.24 percent.

Investors should watch the utilities space closely. Although dividends are generally safe and compose a large portion of total returns, the sector is dependent on many factors. Lower energy demand, higher costs for coal and nuclear power generation, the low price of natural gas, and new environmental regulations can all impact the sector. The sector is undergoing consolidation as companies look for favorable cost synergies and greater investment opportunities, which is positive for share prices.

Vanguard Telecommunication Services ETF

The four-star Morningstar-rated Vanguard Telecommunications Services ETF (VOX) provides investors with concentrated exposure to the domestic telecom industry. The fund seeks to track the performance of the benchmark MSCI US Investable Telecommunications Services 25/50 Index. In addition to telecom providers, the portfolio of 31 stocks includes a tower operator and an information technology services firm. The ETF utilizes a market-cap weighted strategy that creates a top-heavy portfolio with the top 10 holdings accounting for the vast majority of funds under management. The top two holdings, AT&T (T) and Verizon (VZ), compose nearly 50 percent of the portfolio.

Large telecom firms, especially those with a history of stable or growing dividends, offer above-average yields, attracting income-oriented investors. While 31 percent of assets are allocated to small-cap firms, the fund has a 59 percent exposure to large caps and a 9.5 percent allotment toward mid-caps. VOX has an average market cap of $21.13 billion, a price-to-book ratio of 2.23 and a price-to-earnings ratio of 14.99.

VOX has generated total 1-, 3- and 5-year returns of -3.33 percent, 7.69 percent and 7.88 percent, respectively, compared with the category averages over the same periods of -8.80 percent, 5.54 percent and 4.76 percent. The fund has a 3-year standard deviation of 11.95. VOX also has an extremely low 0.10 percent expense ratio versus the category average of 1.47 percent.

The telecom sector is a mature industry, though evolution continues. People are still exchanging landlines for cell phones, and mobile devices are increasingly used for data. The wireless infrastructure is built out, reducing future capital expenditures, which enables companies to generate significant cash flows and pay dividends. There is also a new round of consolidation driving greater economies of scale. How much more consolidation can occur is difficult to determine, as the Federal Communications Commission is working to preserve the current competitive environment.

Outlook

In light of the current market and interest rate environments, investors should use caution with these defensive sectors. The Federal Reserve has begun a rate-hike cycle, and both utilities and telecom are highly indebted industries. They are able to borrow large sums against stable cash flows, increasing their susceptibility to rising rates.

While telecom’s upside is not as great amid a falling market, the risk of missing out on a reversal is lower. VOX is dominated by its top two holdings, leaving it particularly vulnerable to the performance of these two companies. Some investors may prefer owning only those two shares instead of the ETF in favor of higher yields.

For income investors looking toward the long term, a good offense beats defensive strategies. Vanguard’s High Dividend Yield (VYM) offers diversified exposure to the market with a competitive 3.4-percent yield. VYM will not deliver the upside potential of utilities if rates drop, but it will participate in a rally when the market heads higher. Another fund to consider is perennial favorite Dividend Appreciation (ETF: VIG, Mutual Fund: VDADX). While it may not attract short-term income investors with its lower yield of 2.4 percent, it has grown dividends faster over the long haul and holds up well during bear markets.

Both funds may perform well as long as investor uncertainty continues. Nevertheless, these safe-haven investments can quickly reverse if sentiment improves. For that reason, we continue to issue Hold recommendations on each fund; investors may quickly shed these positions as they become increasingly bullish.