I talk a lot in this space about how you can use ETFs to build bond portfolios in the current market environment, and my colleague Russ Koesterich recently explored this topic as well. These applications generally leverage the exchange traded fund (ETF) benefits that many people are familiar with, namely exchange liquidity, low bid/offer spreads and tax efficiency. Today I want to talk about another ETF application that I have been getting a lot of questions from investors about recently: using ETFs for manager transition.
Let’s say that you are having doubts about your core bond holding and want to pull some money out, but you aren’t quite sure where you ultimately want to allocate it. It could take a few weeks to do the proper due diligence and find a new fund, how can you balance your desire to move quickly with your need to make a prudent decision about the new investment? Enter the ETF.
You can sell out of the old fund and use the proceeds to purchase an ETF with similar exposure. In this case, since your old investment was in a core bond fund, you could use the iShares Core U.S. Aggregate Bond ETF (AGG). This allows you to stay invested in the market, continue your exposure to potential yield, and keep your overall portfolio asset allocation unchanged. You have just gone from one core bond fund to another. When you find that new manager you can then sell your investment in AGG and purchase the new fund. The ETF has provided you with a bridge between your old investment and your new one, and has preserved your market exposure along the way.
“But wait!” you might say, “couldn’t I use pretty much any core fund to do this, why use an ETF?” There a couple of properties about AGG that make it especially well-suited for the task. The first is that AGG is an index fund and is designed to track a specific benchmark, in this case the Barclays Aggregate Index. You can look at the fund’s 10+ year track record and see that it has done this pretty effectively over time. The fund holdings are even published every day so you can see exactly what is in the portfolio. When you are looking to use an investment for a short time period this precision is crucial. It means that you won’t be surprised if your temporary core manager suddenly decides to rebalance the portfolio to pursue a new opportunity. This may be appropriate if you trust the manager and have done your due diligence, but this isn’t the type of risk that you want to take while you are evaluating your choices. The ETF shields you from style drift.
The second key ETF property is liquidity. Individual bonds trade over-the-counter (OTC), their prices negotiated between buyers and sellers. Anytime you buy a bond, or buy into a fund that then has to buy bonds, you incur a bid-offer spread. This can make short term investments in fixed income very expensive. Conversely, bond ETFs are traded on exchanges, their prices available to all investors. Putting the bond market on the exchange generally results in lower transaction costs then trading bonds directly. In the case of AGG, it has typically traded with a spread of about 2 basis points.* As AGG is commonly used for transitions like this, along with a variety of other applications, liquidity on the exchange tends to be fairly deep. As of September 29th the 20 day average daily trading volume (ADV) for AGG was over $140 million.