ETF Fixed Income Solutions For The Future
This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Mike Venuto, co-founder and chief investment officer of New York-based Toroso Investments.
November 2016 was a confusing month for most investors. The U.S. equity markets experienced a high-beta rally, which culminated in returns for the S&P 500 of more than 3.5%.
That said, most investors endured very different returns due to intelligent diversification. The table below shows the returns for diversified asset classes in November 2016:
Asset Class ETFs | Nov 2016 |
iShares MSCI EAFE | -1.99 |
iShares MSCI Emerging Markets | -4.67 |
iShares Core US Aggregate Bond | -2.38 |
iShares 20+ Year Treasury Bond | -7.70 |
VanEck Vectors AMT-Free Interm Muni ETF | -4.97 |
SPDR Gold Shares | -7.41 |
S&P 500 TR USD | 3.70 |
Source: ETFresearchcenter.com
Clearly this is an anomaly and will correct over time. Diversification in the long run is usually the right approach, but short-term market reactions can catch even the most astute investor off-guard.
Perhaps the most shocking surprise to most investors came from the losses in fixed-income ETFs. Due to lack of yield, most investors have used fixed income to mitigate volatility, and in the month of November, the exact opposite happened.
So this highlights a concern I discussed in previous research: Do fixed-income ETFs really behave like bonds?
In 2015, I wrote a piece on concerns with fixed-income ETFs and the concept of income barbells.
The main concern identified in my research, in summary, is that although ETFs have democratized access to fixed income, the traditional indexes negate the two most important covenants of a bond:
Maturity
Consistent Coupon/Yield
Even worse, these products, as evidenced by the November 2016 performance, are still subject to duration risk.
Income Barbell Solution
A solution I have employed for many years is the income barbell, which can produce consistent yield and can mitigate volatility. The example in our original research was to simply combine 50% PowerShares CEF Income Composite Portfolio (PCEF) with 50% Guggenheim Enhanced Short Duration ETF (GSY) to generate a consistent yield of about 5%. Below are some examples of the recent performance of this simple model:
Income Solutions | YTD | November | 3 Years Annualized | 5 Years Annualized |
iShares Core US Aggregate Bond | 2.43 | -2.38 | 2.76 | 2.34 |
iShares 20+ Year Treasury Bond | 1.95 | -7.70 | 7.78 | 3.26 |
VanEck Vectors AMT-Free Interm Muni ETF | -1.84 | -4.97 | 3.34 | 3.11 |
50/50 PCEF/GSY Barbell | 6.25 | -0.15 | 3.34 | 4.23 |
Source: Morningstar Direct
Another solution to the perpetual maturity of fixed-income ETFs is to retire the product at a specific date. Guggenheim and iShares have attracted quite a bit of attention and assets by building products that mature by slowly going to cash.
However, the inefficiency of these indexes has created anomalies and drift as the portfolios mature. The portfolios drift from the intended bond category, and many times, the more mature vintages generate negative yields to maturity.
There is a category of bonds that unintentionally may provide a solution to the maturity paradox. Build America Bonds were only issued in 2009 and 2010 as a way to assist states with debt issuance in response to the economic crisis. They are taxable municipal bonds, where the federal government guarantees part of the principal and coupon.
There is currently only one ETF dedicated to Build America Bonds: the PowerShares Build America Bond Portfolio (BAB). The characteristics of the fund are described below and compared to corporates and Treasurys:
Category | Ticker | YTM | Duration | AUM | Expense Ratio |
Build America Bonds | BAB | 3.94% | 9.7 | $1.01 B | 0.28% |
Corporates | LQD | 2.97% | 8.5 | $28.75 B | 0.15% |
Treasuries | TLH | 1.67% | 10.1 | $0.56 B | 0.15% |
TIPS | TIP | 1.57% | 8.1 | 21.1 B | 0.20% |
Source: ETF.com
Unintended Benefit Of BAB
The unintended benefit of the suspended supply of these bonds is that the index will have to mature. The constituents of the BAB index cannot be replaced; therefore, the fund’s duration must decline over time. This is quite different from most bond indexes, which have a semiconstant duration.
Most fixed-income indexes are designed to last forever, so as bonds age and their time-to-maturity shortens, they are gradually replaced in the index by newer bonds with more time to maturity, so that a fund’s overall duration remains relatively stable.
A bond fund that maintains constant maturity will realize losses on bonds it sells that have declined in price. BAB will eventually mature, meaning investors will likely get their principal back if they hold till the product is forced to close. This result can be an interesting solution for investors without the drift concerns with synthetically fabricated target maturities.
One of the greatest attributes of ETFs is their ability to democratize access to asset classes. With fixed income, that same access comes with a price of potentially changing the behavior of the asset.
In summary, when thinking about fixed-income investing, it is important to think more about your intended outcome rather than the past performance of the indexes.
I believe investors seeking consistent yield would be best served through a custom barbell strategy. For investors seeking a bond ETF that truly matures, the only ETF that actually provides this exposure is BAB.
At the time of this writing, Toroso had positions in PCEF, GSY & BAB. Toroso is affiliated with Global X Management Company. Toroso is a New York-based investment advisor focused on researching ETFs and other exchange-traded products, and designing asset allocation strategies, using ETFs that seek to perform well in various economic climates while emphasizing future objectives over past correlations. For more information about Toroso, call 646-465-5930, visit www.torosoinv.com or email info@torosoinv.com. For a list of relevant disclosures, please click here.
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