Mostly Voices [0:00]

A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. If a man does not keep pace with his companions, perhaps it is because he hears a different drummer. A different drummer.

Mostly Mary [0:18]

And now, coming to you from dead center on your dial, welcome to Risk Parity Radio, where we explore alternatives and asset allocations for the do-it-yourself investor. Broadcasting to you now from the comfort of his easy chair, here is your host, Frank Vasquez.

Mostly Uncle Frank [0:37]

Thank you, Mary, and welcome to episode 25 of Risk Parity Radio. Today's episode on risk parity radio comes from a question from one of our listeners, Micah, who asked about XLU, the Utilities Specialty Fund and whether that might be a good option in a risk parity style portfolio. As it turns out, it is, but I wanted to use this question as a springboard for a slightly broader discussion about different parts of the stock market that one might invest in. Now, most of us are familiar with different kinds of stock funds, and you start with your basic total market funds that could cover just the US or the US and the world. And typically those have several thousand different stocks in them, but they are what is called cap weighted. So there is a greater percentage of the largest stocks are the largest companies in the fund and a smaller percentage that's not in the fund. Now there are hundreds, well probably thousands of other stock funds out there. In fact, I believe now there are more ETFs and mutual funds than there are actual stocks. And what a lot of these funds do is try to do what is called factor investing. Now factor investing can be looked at in a number of ways. What it shows you is there are a number of ways you can chop up the stock market. So for instance you could chop up the stock market into large cap companies, mid cap companies, and small cap companies and define those with size metrics and then put those size companies into those funds. Another common factor for slicing up the stock market is growth or value. That's a little more nebulous as to how it's defined, but typically value is defined as companies that have a relatively high revenue or income for the price of the shares themselves. So Often what is called the price to earnings ratio is used to define value stocks and they have a low price to earnings ratio or whichever other ratio that is being used to define the fund. Growth stocks are on the opposite side. They are stocks with high PEs or the other, any other metric you're going to use for that. So they have lower revenue per share, but the idea of those is that they are growing companies aren't expected to have growing revenues and more revenues and become larger in the future and therefore should be worth more. And so you can invest in growth funds or value funds and then they can combine those with size metrics. Now one of the more interesting ways to slice up the stock market that is different from those common factors is to slice up the stock market by sector or what the companies are actually doing in terms of their businesses. And there are several families of funds that do this. Vanguard has a family of funds that's devoted to sectors. BlackRock has a family of funds that's devoted to sectors. But perhaps the most popular ones are the Spider funds that are devoted to sectors. And I thought I would go through those and explain what they are and how they work in relation to the overall stock market. Now, these Spider sector funds all begin with the letter X. They all begin with the letters XL, in fact. And there are 11 of them. It is interesting to look at them because, and I will link to this report in the show notes, because it reveals a lot about what the US stock market is comprised of generally. There are two funds that dominate, or two sectors that dominate the overall market, and they are technology and healthcare. Technology and healthcare together are over 42% of the entire US stock market. Now, if you also add in communications, which includes the companies like Facebook and Google, that's over 50% of the stock market. So when you're investing in a total stock market fund, it is mostly technology, healthcare, and communications. The eight other funds comprise much less, and some of them are actually very small, smaller than you might think. So for instance, the energy sector only comprises 2% of the overall market. Similarly, the material sector, the real estate sector, and the utility sector are all in that 2% to 3% range for the stock market. And that is going to become more important when we start talking about correlations between these sector funds and the stock market. which is where we are eventually going to decide which of these might be useful as an addition to a risk parity style portfolio. But let's go through these and talk about what is actually in them. I'll go through the 11 of them here. The first one is the Communication Services or XLC. There are 26 stocks in this fund. and this fund does divide up the S&P 500. So the total is 500 or rather 505 right now because there have been some spin-offs recently. Now that fund comprises 10.8% of the total stock market and 40% of XLC is Facebook and Google, 40% of it. You'll find that's true for a lot of these funds that are fairly well dominated by the largest companies in them. The next one is the Consumer Discretionary Fund, which is XLY, and that has 60 stocks in it and comprises 11.55% of the total stock market. Now that is dominated by Amazon and Home Depot, and those two companies comprise over 35% of that Consumer Discretionary Fund. The next one is Consumer Staples, that is XLP, that has 32 stocks in it. and that comprises 7.02% of the total stock market or total S&P 500. Now in that the dominant components are Procter & Gamble, Walmart, Coke and Pepsi, and they constitute over 40% of XLP. The next one is one of the smaller funds in terms of market capitalization. It's energy. It used to be a very large part of the capitalization of the US market and now has become a tiny sliver. But it is XLE is the ticker symbol for that. There are 26 companies in that and that is dominated by ExxonMobil and Chevron Texaco. I guess it's just called Chevron these days. And those two components comprise over 40% of XLE. The next fund Sector fund is the XLF, which is the financials. There are 66 companies in that. It's 9.67% of the overall stock market. And that is dominated by three companies, Berkshire Hathaway, JP Morgan and Bank of America. They comprise over 30% total of that sector. Now you'll notice there that it's interesting, including Berkshire Hathaway in that sector. I suppose they had to put it somewhere. It used to have a lot more banks in it. than it does now. Berkshire Hathaway has a lot of Apple stock in it these days. The next sector is XLV, which is the healthcare sector, and that has 63 stocks, and that comprises 14.23% of the entire market. It really is not dominated by any one company. The largest component of it is Johnson & Johnson, which is slightly less than 10%. of that fund. The next one is Industrials and that is represented by the ticker symbol XLI. There are 73 companies in that. That has a weighting of 8.29% of the market. It's not really dominated by any one company or any couple of companies. The largest components are 6% in Union Pacific the railroad and 5% in UPS. the delivery company. The next one is XLB, which is materials, which is probably the least known of the sector funds, and that is only 2.62% of the total stock market. It has 28 stocks in it, and it is dominated by a company called Lind PLC, which is 17% of that fund. And what that company does, I had to look this up, is it It creates industrial gases like oxygen and hydrogen and other things that are used in hospitals or industries or elsewhere. The next one is XLRE, the real estate component of this. That is 31 stocks in it. It is only 2.64% of the total market here. That is dominated by several cell tower REITs. Over 40% of it is comprised of cell tower and data center REITs. The next one is XLK, which is technology, and that is the largest part of the US stock market. XLK has 28.15% of the stock market in it, and it is dominated by Apple and Microsoft, which comprise over 40% of XLK. Now, it's interesting to note that XLC, that communication services fund that we started with used to be part of XLK and it got so ridiculously large they had to split it up and so they put all the communications services in there that include like Facebook and Google, the networks on TV and Netflix and Disney and those sorts of things and then put all the actual hard hardware type technology companies and software service companies like Apple and Microsoft into the technology side of that. It's a little bit arbitrary, but I think they did an okay job with it. And finally, the last one of our sector funds here is XLU, which is the utilities fund that started off this, the Genesis for this particular podcast, and that is only 2.97% Percent of the total of the market has 28 components in it. The largest one in there is 17%, which is next ERA energy, and that's really Florida Power and Light and then another business that does solar and wind and those sorts of technologies within it. Now, knowing what these are is one thing. Knowing whether they would be useful to add to your portfolio is another. And so what we want to think about is the first thing in a risk parity style portfolio is to look at the correlations to see whether any of these sector funds are particularly diversified from those overall total stock market or larger funds that we are likely to have in our portfolio. because we don't want to simply duplicate the same things that we already have. What we want to do is have something additional that might reduce the overall volatility of the portfolio. Alternatively, though, if we find one of these highly correlated sector funds very attractive, because we've looked in our crystal balls and have decided that this is the greatest thing since sliced bread and it's much better than the rest of the market, you could take one of those sector funds and substitute it for an overall total stock market fund or growth fund or other fund in there. But that is really more in the line of stock picking. It's not something that I recommend or I do because I don't have a crystal ball that tells me which of these sectors is going to do well in the future. I know it seems like if you've been in technology for the past 10 years, that you really know what's going on and it's always going to go up and it's the greatest thing. But I can tell you if you were invested in technology in the late 1990s, you probably wouldn't feel that way knowing what happened to it in subsequent years, and you'd be a little more reticent to only focus on those things. So if you've made a lot of money in technology companies, Congratulations. Take it and diversify it if you are getting closer to retirement so that you don't suffer from a new dot-com crash that we cannot predict. But let's take a look at the correlations for these various sector funds. And the way we did this is to go to Portfolio Visualizer and go to the asset correlation calculator and put all of these funds in there to see how they were correlated to the SPY which is the overall S&P 500 from which these are derived. And we did two analyses. We will link to them both. The reason we did two of them is because a couple of these funds have only been around for a few years, namely XLC which was Broken off of XLK a few years ago and reconstituted. And then XLRE, the real estate part of this used to be part of the financials, but that was broken off a couple of years before that. So we did a correlation matrix that includes XLC and XLRE that only goes back to July 2018. And then we did a longer one, which goes back to 1999 for the rest of the funds. And you do see some differences in the correlations. But going through these and looking at the first column, we see that the Consumer Discretionary Fund, XLY, is 97% correlated with the overall stock market fund. The Consumer Staples Fund, XLP, is 85% correlated with the overall stock market. The Energy sector in this analysis is 88% correlated with the overall stock market. Financial Services XLF 93% correlated with the overall stock market. Healthcare XLV 92% I'm sorry 82% correlated with the overall stock market. XLI the Industrials 94% correlated with the overall stock market. XLB the materials sector, 93% correlated with the overall stock market; XLK, the technology, 94% correlated with the overall stock market; and communications, XLC, 93% correlated with the overall stock market. I listed all those together because they are all highly correlated with the overall stock market. So you can see that adding any one of those to the stock portion of your portfolio, assuming you already have some broad-based funds that hold the stock market, isn't going to add any diversification for your portfolio. All this would do would be to add a particular concentration to whatever sector that you are adding to it. It would just be more technology or more communications companies or more health care. And really that is you would do that if you had your crystal ball out and it told you that that sector was going to perform well in the future and you wanted to try and get a better return on the stock portion of your risk parity style portfolio. But it wouldn't give you any better diversification. It wouldn't raise your safe withdrawal rates in any significant manner. And it would not reduce the volatility in any significant manner. But we are left with two sector funds that look a little bit different. And they are XLU, the utilities sector fund, and XLRE, the real estate sector fund. Now we briefly mentioned XLU in episode 23 when we were analyzing a market watch portfolio that we found. And they included XLU and it was actually of the alternative investments in it. It was the most uncorrelated and diversified from the rest of what they were doing. But if you look in here in this analysis, we see that it's 0.58 correlated with the overall stock market. And that is decent for diversification. If you get something at around 0.6 or below 0.6 or even below 0.8, you might have something useful to work with there. And then if we look at XLRE, it is 0.77% correlated for this time period. And I think part of that is because the time period is limited only back to 2018. The correlation is actually much less if you go back for a much longer period of time. So what this kind of analysis tells you is it basically is a shortcut for deciding whether you want to consider a particular fund or asset class in your risk parity style portfolio. Because if it's highly correlated to the most prominent aspect of the risk parity style portfolio, which in most cases is stocks, then it probably isn't worth considering past a simple correlation analysis. And you can put it aside and examine in more detail these less correlated asset classes and fiddle with them and do some analyses to see how they project out over time. But this leads us now to the longer term correlation analysis that goes back to 1999. which does not include XLC or XLRE, but shows some differences. And that's also something that we need to be mindful of, that we are limited in these analysis by the data sets we have. And when you only have a few years of data, it's interesting and it becomes a possibility you really don't have something to hang your hat on entirely until you start talking about 20 years of data or 30 years of data or 40 years or better yet 50 years. Because that's where you're going to get some more confidence that that data is something that is a long-term relationship as opposed to something that was just the way the markets were in that decade or other period of time. But taking a look at this longer data set Going back to January 1999, we do see that some of these funds that were highly correlated in the past few years have a much lower correlation over a longer time period. And in particular, I will call out and this will be linked to as a separate in the show notes. Well let's eliminate the ones that are highly correlated. We see that XLY is 88% correlated with the SPY. So that's highly correlated. XLF, the financials, 83% correlated. Healthcare, 79% correlated. That's getting there, but not that great. XLI, 90% correlated. XLB is actually 81% correlated, so we'll put that in a separate bucket. Really, those funds XLY, XLF, XLV, and XLI are really just highly correlated with the stock market. The ones that are a little bit less correlated with the stock market but still probably not worth considering as separate assets are XLB at 81% and XLK, the technology at 85%. These days we know that technology has come to dominate the stock market and so is 95 to 100% correlated with what the stock market is doing simply because it is the dominant component. But what you do see in here is you have three funds that over the long term have been much less correlated with the overall stock market. And those are XLP, those consumer staples that we have at Procter and Gamble and Coke and Pepsi, those sorts of things. The energy sector, XLE, is 66% correlated. I should say XLP is 62% correlated. And so those are in a range of worthy consideration, although we do know that recently they've been much more correlated with the stock market. And then looking at the bright spot in lack of correlation, we do have XLU, which is only 44% correlated over this period from 1999 to the present. So what that tells you is that again that would be something worthy of consideration in your risk parity style portfolio because of that lower correlation. And with that I see our signal is beginning to fade. We will be doing more episodes about XLU to analyze it in more detail to see whether it might be something you might want to include. in your risk parity style portfolio. And I thank Micah for the question because it is nice to be able to construct some of these episodes about what people are most interested in hearing about. And so I do invite your emails and comments. You can send them to frank@riskparityradio. com that's frank@riskparityradio.com or you can go to the website and fill out the little contact form there and I can get your message that way. We will be picking up again with our portfolio review this Saturday or Sunday. I expected to have it on Sunday. And we will have another portfolio of the week at that time. I have not picked it yet. But thank you for tuning in. This is Frank Vasquez with Risk Parity Radio signing off.

Mostly Mary [24:48]

The Risk Parity Radio Show is hosted by Frank Vasquez. The content provided is for entertainment and informational purposes only and does not constitute financial, investment, tax, or legal advice. Please consult with your own advisors before taking any actions based on any information you have heard here, making sure to take into account your own personal circumstances.