Must know: How bond ETFs reduce portfolio risks

Avik Chowdhury

Performance review: High yield bond ETFs versus industry ETFs (Part 3 of 5)

(Continued from Part 2)

Let us now compare the observations given below with returns during periods of recession. Standard deviation, which is the dispersion of returns from mean, is taken as the measure of volatility or riskiness of as asset.Standard Deviation = √ Aggregation (x-µ) 2 /N

Where x is the observation, that is, value of ETF return; µ is the mean or average of returns; N is the number of observations, that is, number of returns for the period.

Standard Deviation

Cyclical

Bond

SPY

2007-09

0.077

0.043

0.054

2009-14           0.032

0.0307

0.040

Since Jan-14           0.010

0.002

0.008

For the purpose of simplification, we have considered XLY and XRT as cyclical industry ETF class securities; and HYG & JNK as bond ETF class securities. We find that cyclical equity ETFs had been the most volatile. During May 2007–February 2009, standard deviation, or SD of cyclical equity ETFs was 0.077. Compare this to SD of bond ETF for the same period, which is found to be 0.043. Returns from equity ETFs varied between 10.75% returns and negative returns of 23.3%. The relative stability in returns from bond ETFs can be estimated from its range-bound movement between 5.14% and -13.13%.

Now compare the result with the performances of these portfolios during 2009–2013. Standard deviations of SPY and industry ETF portfolio were 0.040 and 0.032, respectively, during the period. Bond ETF portfolio maintained lower standard deviation at 0.0307 for the same period. The volatility or risks associated with cyclical ETFs and SPY remain higher than bond ETFs in recent times as well, as seen in the above table.

So, we may say that although returns from cyclical industry ETFs were higher in the past five years when the economy has performed well, bond ETFs provided better safety in terms of limited volatility when the economic conditions were worse.

Continue to Part 4

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