Short-Duration Funds' Growing Appeal

January 20, 2015

In recent years, fixed-income investors have grown more anxious. Indeed, they’re caught in a dilemma between seeking higher yields and avoiding losses due to looming interest-rate hikes. They yearn for high rates to provide current income, yet safety to avoid significant losses.
 
Fortunately, ETF issuers have not been strangers to this development, and have created several products with effective duration of less than one year, and the possibility of better yields to satisfy this niche. Ranging from active, short-term maturity funds to complex hybrid hedge structures, these funds have been warmly embraced by investors.
 
 
Moving Away From Money Market Funds
 
Not long ago, money market funds (MMFs) were an attractive cash management choice for retail and institutional investors, providing stable income generation with little worry about volatility.
 
Yet in today’s low-rate environment, MMFs do not satisfy investors’ appetite for better yields. On top of that, new regulations adopted by the Securities and Exchange Commission will make MMFs less attractive to yield-seeking, short-term investors and may favor structures such as ETFs.
One of the major regulatory changes is the introduction of floating net asset values (NAVs) for institutional prime MMFs. No longer will MMFs have the implicit safety of $1.00 NAV, and funds may be free to “break the buck.”
Although these cases may be extreme, some managers could see MMFs being not that different from an ETF. However, retail MMFs will continue to have a “stable” NAV.
Other major regulation changes include the decrease in the average maturity of securities in MMFs, down to 60 days or less. While the required lower average maturity makes MMFs safer, it also means lower yields, further decreasing their appeal as short-term income-generating vehicles.
 
 
Active Short-Duration ETFs
 
Investors are aware that higher yields translate to higher risks. Some of them have turned to professional managers to help them navigate through this environment. Enter the actively managed short-duration ETFs.
 
One quick look at a newcomer fund, the First Trust Enhanced Short Maturity ETF (FTSM), helps us realize the robust demand for these ETPs. Launched in August 2014, it already boasts $1.6 billion in assets. Actively managed short-maturity funds leave their trading decisions in the hands of the fund administrator. Their main premise is to beat MMFs on a total return basis. They hold securities such as investment-grade bonds, commercial paper, bank notes, repurchase agreements and, in some cases, foreign-denominated bonds.
 
From being almost nonexistent before 2008 in the ETF space, these funds have steadily accumulated assets (Figure 1). As of October 2014, they hold almost $7 billion in assets under management (AUM).
 
 
AUM FOR ACTIVE SHORT-DURATION ETFs
 
 
The star fund in the sector is the PIMCO Enhanced Short Maturity Strategy (MINT | B), with close to $3.6 billion in assets. MINT aims to keep its portfolio duration under one year, while only holding investment-grade securities. Competitors such as the iShares Short Maturity Bond (NEAR | A) and the Guggenheim Enhanced Short Duration Fund (GSY | A) have raised significant assets as well. One added benefit is the high intraday liquidity, with tight bid/ask spreads, allowing institutional investors to move with ease.
 
 
Hedge Duration With Fixed-Income ETFs
 
Investors looking to manage their duration risk for themselves have a new tool in hedged fixed-income ETFs: a hybrid product combining a long basket of bonds coupled with a short position in Treasury futures.
In case of a rising-interest-rate environment, the short position hedges the bond losses, mitigating interest-rate risk while capturing credit spread. We can easily understand how this structure would appeal to the investor worried by rising rates but still looking for yield. The first hedged-interest ETF in U.S. markets, the Market Vectors Treasury-Hedged High Yield Bond ETF (THHY | D-51), was launched in March 2013. As of October 2014, their number of products has increased to nine. They have collectively amassed over $450 million in assets (Figure 2).
Little surprise that the biggest ETF in the space is the ProShares High Yield – Interest Rate Hedged ETF (HYHG | C-43). With close to $160 million in AUM, HYHG focuses on U.S. and Canadian high-yield notes and shorts U.S. Treasury futures to achieve a zero-duration portfolio.
Investors need to take into consideration that hedged ETFs may not cover complete duration risk due to the convexity of the yield curve. Immunization strategies around these products would result in significant trading costs. Ultimately, investors forgo some yield due to the hedge protection, and in stable range-bound markets, the hedge would act as a drag to the total return.
 
AUM FOR HEDGED-DURATION ETFs

For a larger view, please click on the image above.

The Floaters

Another tool for investors to protect them from rising interest rates is “floater ETFs.” Their underlying securities are floating-rate notes that reset their coupon payments periodically. Thus, interest-rate risk is greatly reduced.
 
They may hold securities rated BBB-, which are on the borderline of the investment-grade space to increase yields.
 
The most representative funds in the sector are the iShares Floating Rate Fund (FLOT | B-96), the SPDR Barclays Investment Grate Floating Rate ETF (FLRN | B-98) and the Market Vectors Investment Grade ETF (FLTR | B-72). All three ETFs are passively managed, tracking indexes of floating-rate notes.
 
However, investors need to be aware that some of the underlying securities are highly illiquid. FLOT is the biggest fund, with $4.1 billion in AUM. Its higher size and daily average volume make it more liquid and provide lower spreads than its competitors. But not all floater ETFs have been successful.
 
ETFs such as the WisdomTree Bloomberg Floating Rate Treasury ETF (USFR) and the iShares Treasury Floating Rate Fund (TFLO) provide investors low-risk vehicles to capital preservation. Yet with minimal risk comes minimal returns. So far, they’ve been shunned by investors, with AUM of $2.5 million and $10 million, respectively.
 
While the current interest-rate environment may not be ideal for these Treasury floaters, at the moment, products with higher credit exposure and hence higher yields are investors’ favorites.
 
Not to be unnoticed, higher interest rates may affect the credit quality of the underlying issuers due to higher coupon payments, and they create larger losses than in other sectors.
 
Even more, the underlying securities can be illiquid, and in some cases, the indexes may be hard to replicate. While funds like FLOT have decent daily volume, other funds have higher market spreads that increase transaction costs. Floaters may have different durations risk depending on their reset periodicity, and that risk is at its highest right after the coupon payment reset date.
 
 
Other Risks & Hidden Costs
 
While using these ETF products fulfills the need for better yield and lower interest-rate risk, short-duration investors may be losing sight of other risks. While seeking yield, they’ve increased exposure to credit-spread risk.
 
In deteriorating economic environments, widening corporate spreads over Treasurys will cause underperformance to other ETF products. Not to be taken lightly, the opportunity cost needs to be factored in as well. Lower-duration protection caps the gains of fixed-income securities when interest rates go lower. In the last few years, investors in the higher end of the yield curve have been rewarded for their risk.
 
Implicit costs such as the expense ratios for these funds need to be taken into consideration, especially in this low-rate environment. These ETF categories carry high administrative costs compared with their passive cohorts. Transaction costs are also an issue, as ETFs are exposed to market-price risk. The bid/ask spreads may be unfavorable in illiquid ETFs and become even bigger in times of market stress.
 
 
What The Future Holds
 
It is anybody’s guess if short-duration ETFs will continue growing in size or if they are a temporary fad. What has been proven is the high adaptation of ETFs to create new products and fill new niches. In the end, more choices benefit all investors.

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