By Murray Coleman
As the gold rush into exchange-traded funds continues, count as innocent victims five seemingly innovative bond portfolios based on the work of Ron Ryan.
You've probably seen his name on these pages before. Ryan was instrumental in creating some of the world's most closely followed bond indexes when he worked at Lehman Brothers. But he struck out on his own in 1982, determined to create a better mouse trap.
"I've been on a mission ever since. Every (index) I've brought to the marketplace tackles a specific investment problem," Ryan says.
His first benchmarks focused on an annoying trait of many bond mutual funds — targeting a range of maturities instead of specific years. Ryan came out with a series of bond indexes where each one follows Treasuries with maturities of either one year, two years, five years and so on. The idea was that money managers could have a pre-fabricated bond ladder.
It caught on with institutions. "Ron's a genius and we know there's a place for this in the market—he's used this same strategy successfully in separate accounts for years," Nicholas Gerber, founder of Ameristock Corp., says in July's ETFR cover story, "Survival of the Fittest." (See story here).
But less than a year after launching the ETFs, Ameristock announced in late May it was pulling the plug on all five it had sponsored.Gerber lamented that with just $13 million in total assets, the unique funds had been buried by an avalanche of bond ETFs diving into the market. (See related story here).
Indeed, by the time of this latest effort to bring fund investors an alternative to buying individual issues to ladder bonds, at least five other Treasury only ETFs were on the market. And last October, less than six months after the Ryan Treasury ETFs launched, the PowerShares 1-30 Year Laddered Treasury Portfolio (AMEX: PLW) came to market.
Combining what the Ameristock ETFs were attempting to do in a single portfolio has proved more successful. PLW now has $47.5 million in assets, despite charging nearly 40% more. Ironically, it also uses an index created by Ryan with the help of data collector Mergent Inc.
The story of the attempts by outside sponsors to find an ETF audience for Ryan's original Treasury indexes goes back even further. In 2002, a group of investors were surprised to find that Treasury ETFs of any kind weren't even in existence yet. So they adopted Ryan's Treasury indexes for their Fixed Income Trust Receipts, or FITRs.
Again, poor timing beset the Treasury ETF series. Right before they launched, Barclays Global Investors unexpectedly beat them to the punch. While BGI's iShares took the traditional approach of setting ranges for their Treasuries, the FITRs couldn't overcome losing first-market mover status and closed shortly afterwards.
Despite the setbacks, Ryan says he remains convinced that ETFs are the wave of the future. Part of that confidence no doubt is due to the relative success of PLW. But at best, he's hitting 1-10 on the bond ETF front.
However, along with Merchant, Ryan's firm has just launched a new set of benchmarks that could improve such a piddling batting average. The indexes target socially responsible investing markets. It's believed to be the first of its kind, says Ryan.
And while he won't say as much, it probably isn't a stretch to figure that a set of ETFs mirroring those SRI benchmarks might be around the corner.
The new indexes are marketed as the KLD U.S. Corporate Bond index Series. The list of acceptable companies that Ryan's firm uses in developing the index is provided by KLD Research & Analytics, which bills itself as the largest SRI indexing firm in the world. It has more than $10 billion in assets tied to those benchmarks.
"SRI investing is very popular. We're hoping to bring that interest we've seen on the equities side to bonds," Ryan says.
There are three in the series: one-to-three years in maturity; one-to-five and one-to-10. "The corporate bond market is skewed to intermediate maturities. We made sure to cover the most popular maturity bands with these products," Ryan says.
He's also working on a longer-term maturity SRI bond index. And his firm, Ryan ALM Inc., also creates custom indexes for institutional clients. It has an indexing division and an asset management division.
KLD looks at the top 1,000 companies by market-cap size. Then they screen them and rank each by SRI factors. Ryan's staff takes the top quartiles from that list supplied by KLD. "We took those top quartile companies and looked at their bonds. Then, we created all sorts of rules," Ryan says.
The benchmarks only include bonds with at least $250 million outstanding for each issue. "So if a corporation had five bond issues and only one of them had $250 million outstanding, we'd only take that one," Ryan said. "We only wanted to take the most liquid issues."
Only investment-grade issues are accepted as well. They also need to have at least one-year call protection on the shortest-term index and a minimum of three years on the others. "Bonds that run out of call protection will get priced to their call dates. And that causes distortions in valuations," Ryan says. "That kind of volatility isn't acceptable."
He has also set a cap of 5% per issuer and the index is rebalanced monthly. The indexes are also equal-weighted. "In bond land, usually the worst a company's credit the more it issues bonds. So you don't want an index to be heavily skewed to the problem issuers as happens with a market-cap weighted index," Ryan says.
"Everywhere you look, major institutions are passing policies to protect themselves against terrorism and political risks. But that's very tough to do," Ryan says.
Having an index that takes on that sort of watchdog duties over should fit right into the current trends of how big pension funds and institutions are investing these days, he adds.
The problem with current bond index funds, Ryan says, is that ETF providers and mutual fund companies make the mistake of trying to replicate corporate bond indices that are just too big. The new indexes will have 125 to 250 different bonds in each.
Next Stop: Tracking Errors
"With the liquidity problems in corporate bonds, they're forced to come up with some sort of sampling methodology. And that just leads to tracking error issues," Ryan says.
It sounds like another great idea from his shop. What if it doesn't work?
Ryan isn't soured on ETFs at all. "I think ETFs are a great investment vehicle, especially as more people move to tactical allocation," Ryan says.
That's different is different from making strategic allocations. "Strategic was very much a static allocation," Ryan said. "By contrast, tactical allocations are more dynamic in nature. They're more responsive to changing investment situations."
In the late ‘90s, he says big pension plans and institutional investors—as well as individuals—let their winnings build up as markets boomed. When times changed, they got hit hard.
"It's like sports. When you're way ahead, you don't keep piling up the score—you change tactics and play more defensively," Ryan said. "That's what we're seeing major corporations doing these days as well as more individuals."
And he doesn't consider tactical allocation shifts to be market timing. "It doesn't have anything to do with what's going on in the market. Tactical allocations are made as you assess where you are in your long-term investment plan," Ryan says. "It's part of a periodic process of taking stock of how far you've come and where you're going."
With the built-in flexibility, transparency and low-cost of ETFs, he believes more sophisticated and investor-focused indexes are bound to keep coming out. "As more investors turn to index-based investing," Ryan says, "the market for indices that can help people tailor their investing will continue to grow."