Why I'm Against Fixed Income ETFs

I’ve made comments recently arguing against bond ETFs. Some of my arguments are really more about the rationale towards low bond allocations in one’s overall portfolio due to the existing, and projected, interest rate environment. Part of it is also the seemingly significant list of weaknesses of bond ETFs versus equity ETFs. I’ve discussed enough about the latter so I want to make a short comment on the former.

Yale University’s Endowment Fund is a top performer in its peer group and the envy of the institutional investing world. I’ve mentioned it by name several times on this blog as have countless others on the web. David Swensen and his group are respected as much for their forward thinking investment philosophy and methodology as their fund’s performance. On the Yale website, the annual reports going back to 2000 are publicly available. Each report shows data as of the last day of June in that year and in each report, the asset mix of the that year and the previous four years are shown on a table near the front of the document. From these annual reports, I’ve put together an asset mix table for this one endowment fund going back eleven years:

Where do I begin?

One observer might say David Swensen is a revolutionary thinker in the institutional investing CIO space. Another might call him a lunatic or at least risky. I think it would be fair to call Swensen risky … in the institutional space, doing anything out of the ordinary and actually implementing an innovative plan would be considered by most to be risky. For example, a 12.5% allocation to fixed income as far back as 1996 with increased bearishness leading to an almost non-existent 3.8% in the latest annual report? Isn’t the purpose of a bond portfolio to provide yields and reduced volatility in the overall portfolio program?

Oh, by the way, when I said “risky”, I meant risky to one’s career. No one in the pension or endowment world wants to take on too much undue risk. They just don’t get compensated (as an employee) in the appropriate way for risk when volatility is nice on the upside. However, risk works two ways of course and if volatility is to the downside, it’s their job that’s on the line. Being close to the median is safe for your livelihood but is it good for the plan? It’s not just Yale but several innovative funds that have led to significant philosophical changes in the industry.

Taking a look at other asset classes, we see that Yale’s endowment fund also looks bearish on US equities having slashed its allocation to this asset class nearly in half over the eleven year time period to a level far lower than what most funds would ever consider to be reasonable. On the other hand, I believe that the foreign equity component would be deemed as reasonable by most investors although the variability in the allocation to this asset class as shown in the table only proves that Yale has been an effective market timer.

If the traditional asset classes of fixed income and domestic stocks have been greatly trimmed, it has been to the benefit of the “real assets” section of the portfolio which includes real estate, oil & gas as well as timber. Interestingly, Yale has had a nearly constant allocation to absolute return strategies (hedge funds) and private equity. In addition, hedge funds have been kept within a range of roughly 20-27% with private equity at roughly 15-25%. Clearly, this fund is a big fan of alternative investments with nearly two-thirds of the fund within this broad classification in the past few years.

Perhaps, if it weren’t for the fund’s great performance, Swensen might have long been considered as an excessive risk taker or worse. Fortunately, in addition to the returns, Swensen’s book Pioneering Portfolio Management provides great clarity in explaining the broad thought process that has underlined the philosophy and methodologies at this fund.

This is only one example of an institutional investor, albeit a very significant one. Bringing this back to the discussion of fixed income investing, you only need to see this chart of long-term interest rates to understand that Yale may have been thinking about reducing its bond exposures well before 1996. In fact, if Yale was a true maverick, the evidence should have led them to reduce these exposures about ten years earlier as shown in this chart.

But clearly, over the eleven year period covered in my table, there was enough evidence from the markets to see that interest rates were moving in one direction on a global scale. Although it’s easy to see this in highsight, the trend was unmistakable as of 1996 so this justifies the low 12.5% allocation to bonds by Yale at that time. Further decreased allocations since then were reasonable as the interest rate decline continued on a global scale to 2006 as shown in this chart:

And so here we are in 2007 with interest rates in a state of limbo (slightly inverted curve over a not so insignificant period of time) and the Fed having held short-term rates constant for longer than many may have thought when it stopped raising rates last year.

But despite all of the above, there’s been considerable discussion lately over fixed income ETFs. After what seems like a “black out” period we’re suddenly seeing new products and more in the pipeline. Could it be with all the talk of yield enhancement focus in products related to infrastructure, real estate and other asset classes, ETF providers are thinking that it’s time to restart the bond ETF assembly line? Considering all this and looking at the line graphs above, you (the bond investor or bond ETF provider) have to think a bit like a market timer and perhaps try to call the bottom of this long-term rate drop. The way the US dollar is going, investors must be thinking about rising rates. With the way the housing situation is playing out, the logic is for rates to drop further. The second line chart above is further evidence of globalization so the added wrinkle of determining if the synchronized fall of interest rates globally will continue is another piece to this puzzle. There are more than enough economists commenting on this and, like them, I feel as though I’m providing way too many questions and no solutions at all. In fact, my only point here is to highlight whether bond investments (ETF or otherwise) are to be a significant component to the overall globally diversified portfolio. Yale, as well as many institutional investors, seems to think not. The recent ramp up of fixed income ETFs seems to show otherwise.

It all depends on:

1. Your income requirements and comfort with volatility that you expect from your portfolio, and
2. To what extent you believe bonds will be (or not be) able to facilitate these roles for your portfolio, and
3. To what extent you believe other asset classes or strategies are effective replacements for bonds within your portfolio.

Comments

[David Jackson:]

Excellent article, Richard.

But what about the iShares Lehman Short Treasury Bond Fund (SHV)? Isn't it just a very convenient and cheap way to buy short term Treasury notes that would actually make sense for a lot of people?

2007 Apr 26 05:53 AM

[dma:]

Richard

For individual investors, there seems to be no effective way to access either the "absolute return" or "private equity" categories you rightly point out as being a huge part of the success of the large endowment investors. That leaves us with cash, stocks, bonds, and real assets (mostly REITs, possibly some commodity plays). Within that restricted universe, bonds could easily end being 10-20% of the portfolio simply for diversification.

2007 Apr 26 07:30 AM

[Richard Kang1:]

DJ & DS: Quick note here. Just had a baby girl late Thursday and got back home now. By chance, checked out SA site. But to make things simple, please put comments/questions on my blog at thebetabrief.com so I can have all inquiries at one place. Sorry for quick get away but there's literally a scream beside me. Thanks.

2007 Apr 28 09:33 AM

[Steve Selengut:]

All Index funds are risky, especially income funds. Use Managed Closed End Funds instead. Here's some recent research with real ife investment portfolios:

Good News For Income Investors



Looking for good news in today's markets is like searching for the proverbial needle in a haystack. Needless to say, practically all investment grade equities and nearly all closed end funds that specialize in providing regular recurring monthly income have been reduced in market value by this prolonged correction. The quake has spread in all directions from its financial epicenter, and the mounting doom and gloom has taken its toll on even the most rational investment decision makers. Try to keep in mind that the purpose of income investing is the income that your portfolio produces not an increase in the securities' market values---



So here's the good news (and for anyone with a 40% or higher income asset allocation, or an income portfolio being used for living expenses), it really is very good news. Base income levels, from the beginning of the stock market correction in June '07 until mid-July '08, have barely changed at all. In fact, they have probably risen in properly asset allocated portfolios. I have examined the regular recurring monthly income distributed by 56 taxable income CEFs and 61 tax-free income CEFs, and the conclusions are pretty remarkable.



In spite of the fact that the vast majority of my favorite monthly income producers are lower in market value than I would like, the amount of income they are distributing to shareholders has not moved lower meaningfully--- even though the Federal Reserve has reduced interest rates by approximately 60% during the past twelve months. Here are the numbers: (1) 48% of the taxable-income CEFs are distributing precisely the same amount per share as they did a year ago. Fourteen issues have increased their payouts and fifteen have reduced them.



The net result is a decrease of just fourteen cents (2.5% of the total monthly payout). The average current yield on the portfolio, as of mid July '07, is 9.86% without considering any capital gains distributions. Additionally, the group is selling at market prices that reflect an average discount of nearly 11% from NAV. Is that special or what? The bonds, preferred stocks, government securities are priced 11% below their current market values.



(2) The numbers are similar with regard to the 61 tax-free income CEFs: 46% have not altered their payout over the past twelve months; eighteen have reduced their payout slightly, and 15 have increased the monthly dole. The net difference for the group over the past year is less than one cent, or a percentage change of two-tenths of one percent. Remarkable. This group is selling at an average discount from NAV of 9.1% and has a current tax-free yield of 5.51%.



(3) Of 117 individual issues, about half have produced stable income. The others have accounted for a total payout reduction of less than 15 cents--- a measly 1.7%. Why is this amount of little consequence? Two reasons really.



First of all, a properly asset-allocated income portfolio does not disburse all of the base income it receives, so there is income available to reinvest in more shares of income producing securities. This process assures a growing cash flow to calm your fear of rising prices. The other reason is a bit more hypothetical. The Fed has lowered rates significantly, a process that normally produces higher prices for income securities. Eventually, those lower interest rates (even if global pressures convince politicians to take back some of the reductions) should produce higher prices (i.e., profit taking opportunities) in these securities.



Admittedly, even if your asset allocation has been fine tuned for years, lower portfolio market values in this area make stock market valuation shrinkage feel even worse. But the value of stable cash flow becomes painfully clear for investors who misguidedly depend on capital gains for their spending money. Properly asset allocated portfolios contain enough base income generators to pay the bills. The purpose of capital gains is to produce proportionately more base income generators.



The purpose of this email is simply to bring some needed sunlight into an investment environment that is far gloomier than I think it needs to be. If you want the details, you'll have to request them personally.





Steve Selengut

www.sancoservices.com

www.kiawahgolfinvestme.../

Professional Portfolio Management since 1979

Author of: "The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read", and "A Millionaire's Secret Investment Strategy"

2008 Aug 19 08:52 AM