3 Important Questions About Your ETF Portfolio

Zacks

With all major stock indexes near their all-time highs, the most important question on the minds of investors is whether this rally can continue and for how long.

Many investors are skeptical of the stocks’ ability to continue their bull-run in the face of unimpressive economic data and corporate earnings.  But since most investors believe that the Fed has been the main force behind the market surge, they have been more focused on any signs regarding the future direction of central bank policy than on the economy.  

No wonder, stock rally hit a brief pause when there were some “conflicting” signals from the Fed about the continuance of the monetary stimulus at current levels. (Read: Invest like Warren Buffett with these ETFs)

And while the long-term bullish trend for stocks appears to be intact for now, chances of a pull back in the near-term cannot be ruled out. This may the right time for investors to review and adjust their ETF portfolios to reduce their risk in the current market scenario.

Do you hold long-duration bond ETFs in your portfolio?

Considering that interest rates will most likely go up from the current levels, it may be a good idea to get rid of all long duration products in your portfolio, as they will be hurt the most in a rising interest rate environment.

Remember very short-term rates will stay low as long as the Fed maintains the fed funds at near zero levels--most likely till the second half of 2015, but the long-term interest rates will begin moving up as soon as market anticipates any likely change in the Fed’s monetary policy.

Yields on the benchmark 10 year note rose above 2%, for the first time since mid-March when the minutes of the recent FOMC meeting revealed that some officials were prepared to start winding down the program from next month.

Recent fund flows reveal that investors are getting increasingly worried about the interest rate risk in their bond portfolios. While interest rate sensitive ETFs had significant outflows, funds with less interest rate sensitivity/shorter duration gathered assets.

Investors could consider switching to shorter duration products or products that provide protection against interest rate rise. Floating Rate ETFs like iShares Floating Rate Note Fund (FLOT) and SPDR Barclays Capital Investment Grade Floating Rate ETF (FLRN) have become increasingly popular with investors of late.

Investors should also look at Senior Loan ETFs like PowerShares Senior Loan Portfolio (BKLN) and SPDR Blackstone / GSO Senior Loan ETF (SRLN) that provide high yields and protection against the potential rise in interest rates. (Read: Buy these ETFs to profit from the great duration rotation)

Are you paying too much for "income"?

Dividend stocks and ETFs have been hot this year as investors continue to chase yield in the current environment of rock-bottom interest rates, and we have been recommending high quality dividend ETFs for quite some time.  (Read: 4 Best ETF Strategies for 2013)

Many dividend focused ETFs have outperformed the broader market this year but some of them look quite expensive as of now. While high dividend stocks and ETFs may retain their appeal in the near- to mid- term, given historically low interest rates, the demand for them may go down slightly due to expensive valuations.

My top pick among dividend ETFs is Vanguard Dividend ETF (VIG), which has Zacks rank #1 (Strong Buy). Unlike some other dividend ETFs that focus on higher yield, this ETF focuses on higher quality of earnings. Further, this product has much lower exposure to rather expensive Utilities (1.3%) and Healthcare (8.5%) sectors, compared with many other dividend focused ETFs.

VIG is currently trading at a P/E ratio of 15.59, which looks quite attractive compared with 18.01 for SPDR S&P Dividend ETF (SDY) and 16.83 for iShares DJ Select Dividend ETF (VYM) –two other very popular dividend ETFs.

Did you buy and forget Leveraged/Inverse ETFs?

Some investors find leveraged ETFs very appealing in a bull market, as they are an easy way to double or triple returns. While these ETFs are perfectly suited to traders, professional investors and hedgers, they are not at all suitable for ‘buy and hold’ investors.

They match their stated objective on a “daily basis” but for any other time period, their performance can vary significantly mainly due to the compounding factor. While ETFs like Ultra S&P500 ETF (SSO) and Ultrapro S&P 500 ETF (UPRO) work perfectly when the market is trending in the same direction, they typically underperform these objectives when the market becomes choppy. (Read: Leveraged and Inverse ETFs suitable only for short term trading)

Further, investors are required to pay high costs (expense ratios) for these ETFs, which eat away at profits.  Then, most of these ETFs use futures and other derivatives to achieve their investment objectives, which in turn result in rebalancing costs.  

We are not saying that these ETF strategies should not be used; they should not be held for a long-term and if held, they need to be monitored closely.

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