Each box represents a different combination of interest-rate and credit-spread scenarios. In theory, INC should do very well in “Box 2” when both rates fall and spreads tighten, as it is getting performance from both underlying risk-free rates and credit exposure.
On the other hand, INC will not do well—much like any other long-only fixed-income instruments—in “Box 4” when it will get hit from both return drivers.
In the scenarios seen in boxes 1 and 3, INC should deliver some decent returns from one of the two drivers. In the end, it boils down to the magnitude of the changes in both risk components.
I’m intrigued by INC’s unique take on the U.S. bond market, but I have to say I’m still unconvinced by its 50/50 target risk composition. I am not sure INC’s strategy will generate enough risk-adjusted outperformance to justify its price tag of 25 basis points when a typical vanilla U.S. aggregate fund charges less than half of that.
We are living in an unconventional monetary policy environment. It wouldn’t surprise me to see rising rates as well as widening of spreads—the “Box 4” scenario. In that case, there’s really nothing anyone can do to protect a long-only bond portfolio. Regardless of your view on the path of interest rates, one thing is clear: INC is a well-thought-out product that provides an innovative take on the two fundamental risk/return drivers in fixed-income investing.
It’s a too bit early to tell whether it will work, but holding all else equal, I might just have enter a very-early nomination for INC as ETF.com’s Best New Fixed Income ETF of 2015!
At the time this article was written, the author held no positions in the securities mentioned. Contact Howard Lee at [email protected].