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Nov. 16, 2016, 12:15 p.m. EST

Five higher risk ETFs for higher yield

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By William Droms

About William

William G. Droms is the co-founder and co-chairman of Droms Strauss Advisors, Inc., a Registered Investment Advisor that specializes in providing wealth management services to high net worth individual investors. He also is the John J. Powers, Jr. Professor of Finance in the McDonough School of Business at Georgetown University, where he teaches investments in the undergraduate and MBA programs. Bill is a graduate of Brown University, holds a Master's and Doctorate in Business Administration from George Washington University and is a CFA charter holder. He is the author or co-author of several books on investments, including Investment Fundamentals, The Dow Jones-Irwin Guide to Personal Financial Planning, The Dow Jones-Irwin Mutual Fund Yearbook, and The Life Insurance Investment Advisor. You can e-mail bill at bill@droms-strauss.com or contact him at droms-strauss.com. Follow Bill on Twitter at @Wdroms.

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Higher return always goes hand-in-hand with higher risk.

Last month we put together a portfolio five ETFs that offer a reasonably conservative group of investments that would improve on the low yields provided by investment grade bonds but not push us out too far on the risk spectrum. This month we're going to take a look at a selection of five riskier exchange-traded funds that offer higher yields than the 3.2% yield on the portfolio of five conservative ETFs.

In reviewing these funds, keep in mind that higher return always goes hand-in-hand with higher risk and moving out on the yield spectrum also moves this portfolio out on the risk spectrum.

Once again, my selection process is simple, but surely not perfect and many alternatives also will work well. I have applied my own conservative bias to the selection process to identify five ETFs that are rated 3 stars or higher by Morningstar and that offer a minimum asset size of $1.5 Billion. Larger asset size generally acts as a proxy for liquidity and allows for ease of trading and tighter bid-ask spreads than in more thinly traded ETFs. In contest to our conservative selections from my last column, not all of these ETFs are rated by Morningstar as possessing low to average risk ratings relative to their category: three are rated as average risk and two as high risk. These ratings help to emphasize once again the higher yields come with higher risker than the lower yielding ETFs. Following are my five choices for a high yield (and higher risk) ETF portfolio.

1. iShares iBoxx $ High Yield Corporate Bond ETF /zigman2/quotes/204471305/composite HYG +0.20%   (5.5% yield, Morningstar 3 stars, 0.50% expense ratio, $17.0 billion assets): HYG is the largest ETF (by assets) in the Morningstar high yield bond category and sports a relatively low effective duration of 3.9 years. As a reminder, duration measures the percentage change of a bond's price in response to a small percentage change in interest rates; for HYG a duration of 3.9 would imply a price decline of 0.98% in response to a 0.25% increase in interest rates. However, high yield bonds sometimes act more like equity than debt, so duration is a pretty wide approximation. Morningstar rates HYG's risk relative to category as average, but bear in mind that junk bonds are a risky category.

2. Vanguard Long-Term Corporate Bond Index ETF /zigman2/quotes/208138770/composite VCLT +1.54% (4.2% yield, Morningstar 4 stars, 0.10% expense ratio, $1.6 billion assets): VCLT offers a portfolio of investment grade corporate bonds: about half of the portfolio bonds are rated A or higher and about half are rated Baa; there are no below-investment grade bonds in the portfolio. The fund is rated for high risk versus category by Morningstar, largely influenced by the high effective duration of the fund at 14.2. Although post-election an interest rate increase in December looks less likely than it did the day before the election, future rate increase will have a strong impact on the prices of the bonds in this portfolio.

3. SPDR Dow Jones REIT ETF /zigman2/quotes/201703743/composite RWR -0.55%   (3.8% yield, Morningstar 3 stars, 0.25% expense ratio, $3.4 billion assets): Our last ETF column included the SPDR® Dow Jones Global Real Estate ETF (RWO; 3.1% yield) and we held RWR to put into our higher yield ETF portfolio. Once again, inclusion of a REIT ETF offers an attractive yield along with solid longer term total returns: the 5-year return on RWR for the period ending 11/8/16 was 10.5% per year. This is the second fund in our high-yield portfolio that has a high rating for risk relative to category.

4. iShares J.P. Morgan USD Emerging Markets Bond ETF /zigman2/quotes/202964510/composite EMB +1.77%   (4.9% yield, Morningstar 4 stars, 0.40% expense ratio, $9.7 billion assets): EMB is the first of two U.S. dollar denominated emerging market bond funds included in our higher yielding portfolio and both of the ETFs are risk rated relative to category as average. But, bear in mind that emerging market debt obviously is a very risky category. Both of these funds have an average credit quality of BB, which is below investment grade.

5. Powershares Emerging Markets Sovereign Debt Portfolio /zigman2/quotes/208792589/composite PCY +2.67%   (5.0% yield, Morningstar 5 stars, 0.50% expense ratio, $4.1 billion assets): This 5-star rated fund tracks an emerging market sovereign bond index but uses equal country weightings and applies a valuation screen to select bonds within the countries in the index rather than a market cap weighing system. The fund's total return performance has been impressive: it ranks in the first percentile for performance within-category for the past 3- and 5-year periods and the 12th percentile for the trailing twelve months. And this sentence is best followed by saying again that past performance is not predictive of future performance.

Using the five choices above, if we create a hypothetical portfolio with 20% of the portfolio invested in each of the ETFs, we would have a portfolio with an average trailing 12-month (TTM) yield of 4.7%, which is 1.5 percentage points higher than the 3.2% on our previous conservative ETF portfolio and 2.6 percentage points higher than the 2.1% yield on the S&P 500. Note also that this riskier ETF portfolio TTM yield also is double the yield of the iShares Core US Aggregate Bond ETF (ticker AGG) yield of 2.3%. The cash yield is double or better than the cash yield on the broad stock or bond market, but we should emphasize again that this ETF portfolio also is riskier than the broad stock or bond market.

On a total return basis, this riskier ETF portfolio would have earned 6.6% over the past three years and 6.7% over the past five years (ETF returns based on price for periods ended 11/2/16) compared to the S&P return of 8.3% and 13.5%, and the Barclay's Aggregate return of 3.6% and 2.8% respectively, for the same holding periods (note that a 60/40 S&P 500/Barclays Aggregate portfolio would have returned 6.4% and 9.3%, respectively, over these two time periods). So this mix would have provided total returns less than the broad stock market and more than the broad bond market. Finally, we do know for sure that past performance does not predict future results and that, coming into what is generally perceived to be the beginning of a period of rising interest rates, it is certainly possible that these high yield ETFs will be adversely impacted on a total return basis if rates rise substantially.

In the interests of full disclosure, I do not own any of the ETFs mentioned in this column in my personal portfolio, but I do own other Vanguard mutual funds and ETFs and I do own two REIT funds (one U.S. and one global), hence may be biased in favor of REITs as long-term investments.

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