Hidden Gem ETFs

December 01, 2017

NuShares Enhanced Yield 1-5 Year U.S. Aggregate Bond ETF

The traditional way of weighting fixed-income portfolios makes no sense. Indexes assign the highest weight to the most indebted countries or companies, loading up on the exact names that should be avoided. NUSA is part of a new generation of bond ETFs that aim to fix that. Using a smarter methodology, it takes a risk-controlled approach to tweaking short-term fixed-income exposure, ratcheting up its yield without making big sector bets. It turns out that matters, because yield is actually the true driver of fixed-income returns.

With rising rates on the horizon, investors are looking to shorten duration. NUSA is perfectly positioned for that. It’s bond indexing 2.0, and you might just want some in your portfolio.

Matt Hougan, CEO, Inside ETFs: Why did you develop NUSA?
Martin Kremenstein, Senior Managing Director, Nushares ETFs: This is a follow-on from NUAG [the Nushares Enhanced Yield U.S. Aggregate Bond ETF], which was a re-imagining and reinvention of the aggregate bond index. In both NUAG and NUSA portfolios, you start with the representative aggregate bond index and then move away from issuance weighting and towards the yield factor. NUSA is aimed at advisors and investors who are looking to shorten their duration while enhancing their yield.

How does NUSA’s return differ from the return of a 1- to 5-year slice of the aggregate index?
It’s designed to garner a higher yield—somewhere around 25-35% higher—by overweighting the higher- yielding parts of the 1- to 5-year aggregate bond index (“Index”) and underweighting the lower-yielding parts. You end up with higher corporate bond and asset-backed bond exposures and a lower Treasury exposure.

How do you build the portfolio?
To start, you take the Index and then divide it into a number of different buckets. You divide it into its constituent asset classes—Treasuries, agencies, securitized products and corporates; you divide corporates into sectors—industrials, utilities and financials; you break down maturities into the 1- to 3-year and 3- to 5-year buckets; and within each slice, you look at different credit ratings: AAA, AA, and so on.

Then, for each of those slices, you can move the weighting up or down by a certain amount based on yield. For instance, you can move BBB-rated financials up or down by 5% against their weight in the Index, and 1- to 3-year Treasuries up or down by 20%, and so on.

You’re overweighting the highest- yielding slices versus the lowest- yielding, but you’re doing so while constraining risk so that it roughly aligns with that of the Index. You’re nudging the portfolio towards a very risk-managed yield weighting, which emphasizes spread return versus duration return.

Why would an advisor want to emphasize spread return over duration return in today’s environment?
The environment doesn’t actually matter. Since the broad aggregate index’s inception in 1976, 94% of the return has come from the yield, and that was during the greatest bull market ever for fixed income. Now that the bull market has come to an end, the return available from price appreciation has nearly evaporated. Now you need to make sure you get the right yield to compensate you for the duration risk you’re taking.

What’s the ideal environment for this fund to deliver on its promise of better total return, and what’s the environment where it suffers?
In any environment where you don’t get a blowout in investment-grade spreads, NUSA should do better than the Index. We keep the duration within 1/8th of a year of the Index, and we keep key rate durations very close as well. So whether rates go up or the yield curve shifts, it should not deviate too much from the Index. You should win by realizing the higher yield.

In an environment where spreads tighten, NUSA could likely outperform the Index. In an environment where spreads remain the same, it should also outperform the Index. If spreads blow out, it’s a question of how long it takes to recover with its higher yield. It’s important to remember that NUSA is not invested in high yield, so the opportunity for a true blowout is substantially reduced.

What is the expense ratio, and how did you price it?
The fund charges 0.20% per year. It’s pretty cheap given the extra yield it’s designed to deliver compared to issuance-weighted funds on the market.

How is the liquidity? What’s your advice to people who want to trade it?
I always advise people to use limit orders. We’ve seen big trades go off without any problem, and just as importantly, midsized trades go off as well. If you have a trade that your block order desk would usually look at, you should have the desk take a look at it. If you usually speak to a market maker, use a market maker; if you usually use limit orders, use a limit order. As long as you are not using a market order, you’re going to be fine. The underlying securities are extremely liquid.

Is there any reason someone would buy the traditional 1- to 5-year Agg, given the improvements in NUSA?
I can’t think of one.

If you had to sum up NUSA in one paragraph, what would you say?
NUSA offers controlled yield enhancement for your short-term fixed-income needs. It’s a complex algorithm to build the portfolio, but it’s actually a very simple story, both in terms of what it does and how it fits in investor portfolios.

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