Bond ETF investors looking to potentially help generate improved risk-adjusted returns can consider alternative indexing methodology.
On the recent webcast, Traditional Fixed Income versus Factor-Based, Edward Kerschner, Chief Portfolio Strategist for Columbia Threadneedle Investments, argued that sourcing income and managing potential income volatility in this new rate regime presents unprecedented challenges for investors.
“There seems to be a logical inconsistency in utilizing a cap weighted bond benchmark as an investment vehicle,” Kerschner said. “The benchmark index weightings do not foster diversification, with correlations among the components high; positioning investors in the low return/low volatility segment of the market.”
Alternatively, Kerschner advised investors to consider a multi-sector bond strategy that screens for opportunities. Investors seeking higher returns could should move out along the risk-reward profile as an alternative indexing methodology that is not restricted by traditional market capitalization weights could address the investment universe screened by yield, quality and liquidity
Looking at the current market conditions, we see that benchmark U.S. Treasury yields are finally pushing up after falling from 15% back in 1982 to under 2% in 2013 due to loose central bank policy rates and quantitative easing.
“The risk today is that with bond yields so low, a modest uptick in yield would produce negative returns,” Kerschner said.
During the three-decade long bull run that helped push yields to record lows, many passive bond investors have enjoyed strong returns through diversified exposure through something like the Bloomberg Barclays US Aggregate Bond Index. The so-called Agg was comrpised of 9,397 debt securities worth almost $20 trillion.
However, the Agg is not what is use to be. The Agg held 22% U.S. Treasuries back in 2007, but that exposure has increase to 37% of the index today. Factoring in debt issued by government agencies and mortgage-backed securities, the total government exposure is now over 70%, which leaves investors overexposed to a single segment of the market and susceptible to interest rate risks – MBS pass-through and agency securities exhibit a high 0.81 and 0.93 correlation to U.S. Treasuries.
“Fixed-Income investors limit their opportunity set by focusing on the benchmark-tracking or benchmark-hugging strategies,” Gene Tannuzzo, Senior Portfolio Manager for Strategic Income Columbia Threadneedle Investments, said.
On the other hand, Kerschner argued that there is diversification potential if you examine other sectors of the bond market. For example, investors heavily benchmarked to something like the Agg may diversify their portfolios through exposure to other yield-generating opportunities, such as high yield, corporate debt, global Treasuries and emerging market debt, which have much lower cross-correlations to U.S. government debt.
“Moving out along that risk-reward profile finds opportunities that are both less correlated and have historically offer relatively high returns,” Kerschner said.
With a well-defined strategy, an investor can manage the potential added risks that come with these higher yield-generating ideas. Tannuzzo pointed out that a bond strategy filtered for opportunity rather than indebtedness may be an attractive alternative. For instance, a yield filter may include multiple sectors throughout the U.S. and around the globe; a quality filter can avoid the “tails of the market” by removing sectors that offer no risk premium and lower quality tiers that have outsized risk; and a liquidity could focus on issues with sufficient tradability to provide investors with liquidity, managed against volatility.
Specifically, the Columbia Diversified Fixed Income Allocation ETF (NYSEArca: DIAL) follows an alternative indexing methodology to potentially help bond investors garner improved returns and potentially diminish the negative effects of sudden swings by implementing rules-based screens to covers six sectors of the debt market, focusing on yield, quality and liquidity factors.
The underlying index tries to target the six sectors, including U.S. Treasury securities (10%); global ex-U.S. treasury securities (10%); U.S. agency mortgage-backed securities (15%); U.S. corporate investment grade bonds (15%); U.S. corporate high yield bonds (30%); and emerging markets sovereign and quasi-sovereign debt (20%). Each sector is market value-weighted except for the global ex-U.S. Treasury Securities, which is equally weighted.
“The first ETF of its kind, DIAL provides convenient access to six sectors, attractively priced and managed by senior fixed income portfolio managers,” Jay McAndrew, National Sales Manager of Strategic Beta for Columbia Threadneedle Investments, said.
Financial advisors who are interested in learning more about fixed-income strategies can watch the webcast here on demand.