In our view, one of the most important catalysts behind the increased popularity of exchange-traded funds (ETFs) is the ability to create broad-based portfolios with only a handful of trades. Fixed income ETFs cover a wide spectrum of investment sectors and can be combined to help achieve many different objectives. Zero and negative duration bond portfolios take this idea a step further by combining commonly followed fixed income strategies with interest rate overlays to achieve a desired exposure to interest rate risk. Today, ETF investors can preserve their existing fixed income strategy while reducing their overall sensitivity to interest rate risk, in much the same way that large, institutional money managers have managed risk for decades.
Rising Rate Suite Explained
As highlighted in our white paper on navigating a rising rate environment, WisdomTree’s suite of rising rate products begin with exposures to bond indexes that many fixed income investors are familiar with, namely the Barclays U.S. Aggregate (“Agg”) and BofA Merrill Lynch High Yield. The second step of the portfolio construction process involves quantifying the resulting interest rate risk in a series of buckets from the long-bond portion and selling Treasury futures contracts in order to hedge interest rate risk. In the case of the negative duration strategies, hedging is taken a step further in that longer duration futures contracts are sold in order to target a negative five- or negative seven-year exposure. As a result, WisdomTree’s suite of rising rate products provide an interest rate risk tool kit that investors can combine with other risk-sensitive assets to obtain their desired trade-off between income potential and interest rate risk.
Incorporating the Rising Rate Suite into Investor Portfolios
By using the Barclays U.S. Aggregate Index as a proxy for a hypothetical investor’s portfolio, the graphs below depict the trade-off between yield and interest rate risk across a variety of combinations of traditional and enhanced exposures. Incorporating zero duration strategies in the hypothetical portfolio results in some drag from the short positions in the strategy but provides a proportionate reduction in overall interest rate risk. Similar allocations to the negative duration strategies can provide a more significant reduction in interest rate risk but entail a higher cost from the short positions. Additionally, investors are also potentially exposed to investment losses, should interest rates fall or the yield curve not change uniformly across all maturities. Investing in high-yield strategies versus aggregate strategies mitigates the costs of the short positions but can result in potentially higher volatility and credit risk within the portfolio.