All this back and forth between theory and practice made me think about one of Yogi Berra’s great quotes: “In theory, there is no difference between theory and practice. But in practice, there is.” Our look at zero duration ETFs is merely an attempt to see how big the difference might be. They seem to largely—but not totally—eliminate interest rate risk and provide focused exposure to credit risk, while high-yield ETFs also add a pinch of equity market risk. When theory meets practice, real-life challenges and constraints can have notable and potentially unexpected effects on our ability to fully implement portfolios that, in principle, seem more straightforward.
I would like to thank my colleague Craig Gross for his contributions to this blog.
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1 Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.
2 Eugene F. Fama and Kenneth R. French, 1993. Common risk factors in the returns on stocks and bonds. Journal of Financial Economics 33:3–56.
3 Investment-grade is a rating that indicates that a municipal or corporate bond has a relatively low risk of default.
Jim Rowley, CFA, is a senior investment analyst in Vanguard Investment Strategy Group, where he leads the team that conducts research and provides thought leadership on issues related to indexing and ETFs.