The Sky Is Falling ETFdb Portfolio

Published on September 11, 2009 | Updated February 11, 2014

Portfolio Strategy

Short to Intermediate Time HorizonLow Risk ToleranceHigh Current IncomeThe Sky Is Falling ETFdb Portfolio is designed for investors who are pessimistic on the short term outlook for the U.S. and broader global economy. Our inspiration for this ETFdb Portfolio comes from several sources, including gold bugs like Bud Conrad, advocates of commodity investing like Jim Rogers, and noted value investors like Warren Buffett. We have also taken note of countless analysts and investors predicting a “double dip” recession.

We have tilted this ETFdb Portfolio heavily towards low-risk investments that tend to perform well in uncertain or adverse economic environments, including gold, commodities, and inflation-protected securities. While we retain a small allocation to equities in this portfolio, this portion is dominated by value and defensive equities that generally experience smaller declines in down markets. While some investors may wish to avoid exposure to equities altogether in bear markets, we believe that ignoring this asset class completely is short-sighted, and as such have given a a quarter allocation to equities. This allows investors to participate in any upside if the markets rise while limiting the downside risk in a bear market.

This ETFdb Portfolio likely will not return huge gains in a bear market, but should do an excellent job of preserving capital as more aggressive strategies face significant declines. Investors wishing to make a more aggressive bet on declines in the equity markets may wish to eliminate all equity holdings from the portfolio, or perhaps even consider the inclusion of inverse equity ETFs.

  • Risk Tolerance: Low. This portfolio is designed for active investors looking to shift away from risky investments towards risk-free securities in the face of a coming bear market. With a focus on capital preservation in a rocky economic environment, this ETFdb Portfolio is constructed to minimize volatility and declines in asset value.
  • Time Horizon: Short. For all but the most risk averse investors, an allocation of 25% to equities is inappropriate over the long-term. This ETFdb Portfolio is designed for use by investors utilizing a tactical asset allocation strategy, shifting their asset class allocations as economic outlooks change.
  • Current Income: High. This ETFdb Portfolio is weighted towards fixed income investments that provide a relatively stable return. Even the equity portion of this ETFdb Portfolio is weighted with value stocks that tend to exhibit high dividend yields.

Portfolio Snapshot

Below are the holdings and allocations for the Sky is Falling ETFdb Portfolio. For each ETF included in this portfolio, we have also provided alternative funds that offer similar exposure.

Ticker ETF Asset Type Allocation Expense Ratio Alternative ETFs
DEF Guggenheim Defensive Equity Index ETF Domestic Equities 10.0% 0.60% IJJ, VOE
VTV Vanguard Value ETF Domestic Equities 5.0% 0.10% DVY, PWV
VBR Vanguard Small Cap Value ETF Domestic Equities 5.0% 0.21% IJS, VBR
VEU Vanguard FSTE All World ex-U.S. ETF International Equities 5.0% 0.18% ACWX, CWI
SHY Barclays 1-3 Year Treasury Bond Fund Fixed Income 25.0% 0.15% TUZ, BIL
TIP iShares Barclays TIPS Bond Fund Fixed Income 20.0% 0.20% TIPZ
SGOL ETF Securities Physical Swiss Gold Shares Commodities 10.0% 0.39% GLD, IAU
DBC PowerShares DB Commodity Index Fund Commodities 10.0% 0.93% DJP, RJI
VXX iPath S&P 500 VIX Short Term Futures ETN Volatility 10.0% 0.89% VXZ
Weighted Average Expense Ratio 0.38%  

Historical Return Analysis

Ticker 2009 2010 2011 2012 2013
DEF 22.3% 19.5% 13.0% 7.2% 22.4%
VTV 19.9% 14.6% 1.1% 15.2% 33.1%
VBR 31.0% 25.2% -4.2% 18.9% 36.5%
VEU 37.7% 11.8% -14.0% 18.9% 14.2%
SHY 0.4% 2.3% 1.4% 0.23% 0.22%
TIP 9.0% 6.2% 13.3% 6.4% -8.5%
SGOL n/a 29.3% 9.6% 6.6% -28.3%
DBC 16.2% 11.9% -2.6% 3.5% -7.6%
VXX n/a -72.4% -5.5% -77.6% -66.5%
Portfolio n/a 3.2% 3.6% -2.0% -5.4%
Compare to SPY 26.3% 15.0% 1.8% 16.0% 32.2%
Compare to AGG 3.3% 6.4% 7.7% 3.8% -2.0%

The adjacent table provides historical results for each component of this ETFdb Portfolio, as well as backtested results (as available) for the entire portfolio from 2008 to 2012. The table also shows how this ETFdb Portfolio performed relative to a popular stock market benchmark (SPY) and bond benchmark (AGG).

Not surprisingly, this ETFdb Portfolio struggled in 2008 and again in 2011 during a broad market recession. In 2009 and 2010, this ETFdb Portfolio reclaimed much of the ground lost during 2008, doing the same in 2012 for its 2011 slow down.

The dismal equity returns during the market slump of 2008 highlights the importance of maintaining even a fairly minimal allocation to fixed income ETFs in this ETFdb Portfolio. Notice how all of the bond funds included in this portfolio were able to post positive returns during the stock market rebound in 2009 and 2010.

Portfolio Expenses

Although this ETFdb Portfolio is not designed for long-term investors, it is constructed to minimize expenses over the short term. Although the commodity and volatility ETFs included in this ETFdb Portfolio have expense ratios above most exchange-traded products, they remain well below fees charged by traditional actively-managed funds. The weighted average expense ratio of this ETFdb Portfolio is 38 basis points, which is significantly lower than fees charged by actively-managed mutual funds. The impact of this reduced costs structure over the horizon of this portfolio is significant:

    Growth of $1 Million Over 10 Years @ Annual Return Of:
Portfolio Expense Ratio 5% 10% 15%
The Sky Is Falling ETFdb Portfolio 0.38% $3,873,182 $15,715,813 $59,906,109
Actively-Managed Mutual Fund Portfolio 1.00% $1,480,244 $2,367,364 $3,707,221

Holdings Overview

Asset Allocation Sky Is FallingBelow is a brief overview of each component of this ETFdb Portfolio.

  • DEF: This ETF is designed to invest in securities characterized by low relative valuations, conservative accounting, dividend payments, and a history of outperformance during bearish market periods. This ETFs holdings are determined through a proprietary stock evaluation and selection process. DEF is dominated by holdings in large cap and mid cap equities.
  • VTV: This ETF tracks an index that is designed to represent the large cap value segment of the U.S. equity markets.large cap equities tend to maintain lower volatility than small cap stocks, while value companies offer higher current returns than their growth counterparts/
  • VBR: This fund offers exposure to small cap value segment of the U.S. equity markets. While small cap equities are generally more risky than larger firms, this ETF provides some degree of diversification within the equity component of this ETFdb Portfolio.
  • VEU: This ETF tracks an index that includes about 2,200 equities in 50 countries outside the U.S. This ETF maintains part of its holdings in emerging markets, which can be volatile. While investments outside of the U.S. have historically perceived to be more risky than domestic equities, we have seen several recent crises originate in the U.S., an indication that some degree of global diversification is warranted.
  • SHY: This ETF invests in the short-term sector of the U.S. Treasuries market, holding dollar-denominated securities that have a remaining maturity of between one and three years. Because SHY limits its holdings to Treasuries, it offers a consistent, low expected return.
  • TIP: This ETF invests in inflation-protected securities, meaning that the principal of the underlying securities increases with inflation (as measured by CPI). Therefore, real returns on TIPS are guaranteed regardless of the level of price increases that may eat into nominal returns of equities and other fixed income investments.
  • SGOL: This ETF holds gold bullion stored in secure vaults in Switzerland. As a “safe haven” investment, gold has historically experienced significant price appreciation during times of economic uncertainty.
  • DBC: This ETF invests in a diversified basket of commodities, including crude oil, gold, aluminum, corn, and wheat. Since investors tend to view many of these commodities as stores of value in bear markets, they can experience healthy returns during downturns.
  • VXX: This ETF tracks the performance of a basket of futures on the S&P 500 Index. Since equity markets tend to experience significant volatility in uncertain economic climates, this fund can serve as an excellent hedge to equity investments. The VIX Index traded near $60 in October 2008, but had dropped to below 25 by September 2009.

Portfolio Risk Overview

This ETFdb Portfolio is dominated by investments in fixed income securities and other asset classes that have historically had a low or negative correlation with broad equity markets (including commodities and volatility). Among the modest allocation to equities is a significant tilt towards defensive and value stocks, allowing investors to participate to some degree in a bull market but limiting downside exposure.

Equity Overview

The Sky Is Falling ETFdb Portfolio contains an allocation of 25% to equities, including domestic and international stocks. Approximately 50% of this ETFdb Portfolio’s equity holdings are giant and large cap stocks (which generally have a market cap of more than $10 billion), while another 35% is in mid-cap stocks.

Defensive equities generally include companies that face relatively consistent demand for their products. While these companies may lag behind discretionary spending firms during economic booms, defensive equities will generally experience less price depreciation during downturns. Among DEF’s largest sector allocations are utilities, consumer staples, and healthcare, three sectors that tend to experience relatively stable demand regardless of the broad economic health.

Value ETFs, such as VTV and VBR, focus on companies with low price-to-earnings, low price-to-book ratios, and high dividend yields. Financial institutions, energy companies, and industrial firms often receive significant allocations in value ETFs. Among VTV’s largest holdings are traditional value firms such as Exxon Mobil, JP Morgan, and AT&T. VBR has major allocations to Genworth Financial, AIG, and Oshkosh Truck Corp.

The equity portion of this ETFdb Portfolio is dominated by stocks listed and operating primarily within the United States, but also includes a moderate weighting to international equities. The inclusion of international equities through VEU adds geographic diversification to this ETFdb Portfolio, and further protects against a collapse in the U.S. economy. As cross-border investment restrictions have been eased, correlation between domestic and international equities has strengthened, although the inclusion of some international equities does add moderate diversification benefits.

DEF [Fact Sheet]

DEF is designed to invest in companies with a history of outperformance during bear markets by identifying firms with conservative accounting practices, stable dividends, and low relative valuations. DEF’s highest sector allocations are to utilities and consumer defensive companies, with relatively little weight given to the basic materials and technology industries.

VTV [Fact Sheet]

In order to soften the blow to this ETFdb Portfolio in the event of a sharp economic downturn, we have made an allocation to the Vanguard Value ETF, VTV. While value equities would likely lose value is a “worst case scenario,” we believe value stocks should retain their value well relative to growth stocks due to generally higher cash balances and stable earnings power. Moreover, we believe that obtaining some degree of broad market exposure is advisable in any environment.

VBR [Fact Sheet]

In addition to VTV, we have decided to maintain a small allocation to small cap value equities in this ETFdb Portfolio. VBR is one of the cheapest options available for investors looking to gain diversified exposure to small cap equities, with more than 1,000 individual holdings and an expense ratio of just 21 basis points.

VEU [Fact Sheet]

In order to provide some degree of geographic diversification to the modest equity component of this ETFdb Portfolio, we have made a small allocation to Vanguard’s All-World ex-U.S. ETF. This ETF spreads its holdings across 2,000 companies in more than 40 different countries.

While “ultra-bears” may be hesitant to include any stocks in their portfolio, we believe that some degree of equity exposure is appropriate for almost every investor. Consistent with the stated goals of this ETFdb Portfolio, we have limited the size of our equity stake to one quarter, and limited the scope of this stake to companies that should outperform broad equity benchmarks in a bear market.

Fixed Income Overview

Despite the diversification across sizes and geographies within the equity component of this ETFdb Portfolio, many of these funds maintain relatively high correlations with each other (as evidenced below). In order to smooth overall volatility and avoid anticipated declines in equity markets, we have allocated almost half of this ETFdb Portfolio to two fixed income funds: SHY and TIP.

Most portfolios, including those designed for risk averse investors, will include an allocation to investment grade corporate bonds and securities issued by U.S. agencies. However, in times of economic crisis, bond prices tend to decline as well as the likelihood of default rises among debt issuers.

Given the investment thesis of this ETFdb Portfolio, we have decided to achieve the entirety of fixed income exposure portfolio) through low-risk U.S. Treasuries, a popular safe-haven in times of equity market turmoil.

SHY [Fact Sheet]

SHY invests in debt issued by the U.S. government with a relatively short maturity (a weighted average of approximately two years). Since time to maturity and sensitivity to changes in interest rates are positively correlated, this ETF will not suffer large declines when interest rates rise (and likewise it will not appreciate significantly if rates decline). Because SHY invests exclusively in debt issued by the U.S. government, it is likely to be a popular safe haven in a “sky is falling” scenario.

TIP [Fact Sheet]

In addition to SHY, this ETFdb Portfolio protects against upticks in inflation by holding TIP, an ETF that invests in inflation-protected Treasuries. The face value of inflation-protected securities increases with CPI, which results in higher coupon payments in high inflation environments. We believe that an allocation to TIPS is a vital component of any client portfolio in the current economic environment, and deserve a significant allocation among fixed income investments in most situations.

Overall, this ETFdb Portfolio’s fixed income holdings are limited to high quality bonds issued by the U.S. government, and have a significant bias towards shorter maturities to avoid excessive exposure to changes in interest rates and declines in the health of the corporate bond market.

Commodities and Volatility Overview

We generally believe that due to their low long-term rates of return and occasional short term volatility, commodity ETFs do not deserve a significant allocation in long-term buy-and-hold portfolios. However, investors tend to flock to commodities when prospects for equity markets deteriorate, making SGOL and DBC critical components of The Sky Is Falling ETFdb Portfolio.

SGOL [Fact Sheet]

Gold has a strong negative correlation with both domestic and international equities, and has been proven many times over to be a popular safe have investment. When choosing between SGOL and the much larger GLD, we gave the nod to the ETF Securities product because it stores its gold in Swiss vaults. Although another confiscation of gold in the U.S. (it happened in 1933) is unlikely, the last two years have taught us that anything is possible. However, these two ETFs are effectively interchangeable, and investors should have no worries about investing in GLD.

DBC [Fact Sheet]

In order to diversify exposure to commodities, we gave a one tenth allocation to DBC, which holds diversified investments in six major commodity classes (including further allocations to gold). With investments in aluminum, corn, gold, heating oil, light crude, and wheat, DBC provides exposure to the most widely-traded commodities in the world. These assets tend to appreciate significantly in tough economic environments as investors cash out of equities and seek out effective stores of value.

VXX [Fact Sheet]

Instead of allocating a portion of this ETFdb Portfolio to a money market ETF, such as USY, we elected to maintain a one tenth allocation to VXX, which is tied to the implied volatility of short-term options on the S&P 500. Since expected volatility often rises in downward trending markets, VXX may see some nice price appreciation as the equity markets turn.

Many investors have learned the hard way that correlations between many asset classes trends towards 1.0 just when it is needed most – times of economic instability. The relationship between VXX and equity markets is quite the opposite. For most of its 20-year history, the VIX Index has maintained a slight positive correlation with equity markets. But in 2008, correlation between these assets went towards negative 1.0 as equity markets plummeted and volatility surged. We think of VXX as portfolio insurance to hedge against (or in this case, profit from) a severe market downturn.

ETF Correlation Matrix

Diversification is a key component of any client portfolio. The following chart shows the correlation between each component of The Sky Is Falling ETFdb Portfolio over the last two years.

As is expected, there is a fairly strong correlation between the equity components in this ETFdb Portfolio, including between domestic and international equities (both developed and emerging markets). But the correlation of DEF with the other equity ETFs has historically been around 0.70, much lower than average correlations between domestic equity ETFs, which can be as high as 0.95.

As evidenced by the abundance of green in the correlation matrix, the remaining holdings of this ETFdb Portfolio maintain low or negative correlations with equity markets, particularly SHY and VXX. It is also worth noting that the commodity components maintain relatively low correlations with fixed income investments, a fact that should help to smooth out performance during rocky economic times.

Disclaimer

The information herein is not represented or warranted to be accurate, correct, complete, or timely. Past performance is no guarantee of future results. All investors should read applicable prospectuses before investing.

From time to time, the authors of this report or other employees of ETF Database may have a long or short position in securities referred to herein. The factual statements herein have been taken from sources we believe to be reliable, but such statements are made without any representation as to the accuracy or completeness or otherwise.