Fixed Income Fund Alternative to Bond ETFs

Includes: CIU, LQD, SHY, TBT, TLT
by: Lee Eugene Munson, CFA

Co-written by Kristina Nissen

Continuing with the theme of addressing core fixed-income asset allocation, we now move on to trading strategy. Our firm recently published the report “3 ETFs to Protect Against the Interest Rate Risk in 2011”. But if you want to take investing to the next level, specifically in the realm of treasuries, you should look at our friend Kirk Barneby, Portfolio Manager and lord of the Rydex SGI Long Short Interest Rate Strategy Fund (RYBUX).

To gain a better understanding of what Kirk’s fund actually is and to prevent further eye glazing, it’s easier to read the fund’s name from back to front. The fund is a “Strategy Fund”. What does this mean? It means this is Kirk’s strategy based on a model that he has worked on for over 30 years. Fundamentally, his strategy is about absolute return and profit. “Interest Rate” fund is entirely accurate in the sense that this fund deals with one investment vehicle: treasuries. Notice the title does not say treasury. Why? Because when you use U.S. liquid treasury futures, you get rid of all earnings and credit risk. When these are no longer an issue, the focus is only on interest rates. Rydex goes so far as to not use the word treasury in the fund. In fact, when Rydex first came to us, they referred to it as a Long Short Treasury Fund. Kirk made a strong case that when you use only treasuries; all you have left is pure rate exposure.

Next, don’t let the phrase “Long Short” confuse you. It does not insinuate that Kirk is long and short treasuries simultaneously. Kirk is either long, or he is short. The fund is directional. Meaning that based on the model output, the fund will strategically move within five stages from fully bearish to fully bullish. Finally, “Rydex SGI,” is ultimately in the (big) business of selling products. They’ve acknowledged that investors are worried about interest rate volatility. They’ve also acknowledged that not all investors can invest in bond ETFs such as iShares Barclays 20+ Year Treasury Bond (NYSEARCA:TLT), and inverse ETFs like ProShares UltraShort 20+ Year Treasury (NYSEARCA:TBT) without having a crystal ball that predicts interest rates entirely. Anyone can recognize that there is a market for investors that want to speculate on interest rates, but don’t have the time or means to execute a strategy. Because trading rates is hard! We trade treasuries every day ... and it’s not all sunshine and rainbows. There’s second-guessing on interest rate trends, there’s volatility and at the moment, they’re not paying high rates. All we’re saying is that having a manager that has a strategy is a better idea than riding in the rodeo for the first time. Lastly, this is one of the few funds in which Rydex hired an outside manager, which we think is a sign of confidence. What the fund should really be called is “Rydex Recruits Kirk’s Life Long Experience Trading Rates And Makes It Into a Sellable Product Fund”.

So, finally the burning question you’ve been asking: What is this model! After spending hours one on one with Kirk during a Chicago conference, we got a glimpse of his strategy and how to philosophically look at the fund. His quantitative model, which is forecasted monthly, encompasses three fundamental components: economic outlook, inflationary expectations and investor psychology. Economic outlook deals with variables such as employment, production and economic growth. Inflationary expectations consider items such as prices of commodities and other inflationary measures. Finally, investor psychology looks at how overbought or oversold the market is and how market fluctuations are not always explained by the former two components. Based on this, Kirk’s fund creates an outlook, and moves towards specific target durations ranging from positive to negative duration. What this means in simpler terms is that Kirk can allegedly make you money with both the rise and fall in interest rates.

Kirk is ultimately trading. He found a way to take out credit risk, earnings risk and liquidity risk by using U.S. Treasuries. He is using the most liquid security known to man and he can access the futures market to gain long or short exposure fast and cheap. All that is left is the direction of rates. When his model indicates rates will go up, he wants to be in short term Treasuries, or even in extreme cases, sell-short Treasuries. When the model indicates rates will go down, he goes for longer dated bonds. As you may be able to tell, this is about absolute return. He is not a bond picker. The fund is not trying to figure out if the debt of company X will be upgraded. Rather, Kirk is using a system that he has worked on for decades to make a profit. Therefore treasuries are simply a means to an end.

So how is this useful to you? Is this a replacement for a bond fund? Or is this a hedge fund strategy? It could be difficult to say. Kirk’s fund is not investing in fixed income in the traditional sense of long only. Also, it is not an inverse fund like TBT that exist to capture the rising Treasury rates. The fund is designed for one thing and one thing only: profits. Undoubtedly, Kirk has something special that Rydex wanted. Special doesn’t mean it’s guaranteed to work, it simply means there is confidence in it. Is it right for you? That’s ultimately for you to decide. All we’re suggesting is Kirk’s fund may serve as an alternative to some of your fixed income allocation. Just know that this is a strategy, not an asset class. And you care because until now, you had to call the direction of interest rates on your own.

Disclosure: I am long CIU, SHY.