‘Off Benchmarking’ Fixed Income ETFs

April 25, 2016

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Corey Hoffstein, co-founder and chief investment strategist of Boston-based Newfound Research.

Stocks get all the attention. Perhaps for good reason: The volatility they exhibit means they often have the biggest impact on investor wealth. All that volatility means opportunity, risk and, if we’re being honest with ourselves, quite a bit of excitement.

For many, fixed income is an afterthought. Unlike stocks, the day-to-day for fixed income can be like watching paint dry.

As investors enter retirement, however, wealth accumulation must transform into thoughtful distribution. The new goal should be to maximize withdrawal rates without risking premature erosion of the capital base.

While stocks may remain the focus of the financial media, these investors should turn their eyes toward bonds.

The Tougher 4%

Unfortunately, with the 10-year U.S. Treasury rate below 1.8%, how and where to find yield in the distribution phase has become a struggle. While investors might be trying to achieve the same 4% distribution target they earned a decade ago, 4% represents a very different risk level today.

From a risk perspective, the target level is less important than the spread that the level implies from a baseline benchmark. For example, a decade ago the one-year U.S. Treasury constant maturity rate was 4.9%. Today the same rate is 0.52%. Based on spreads, achieving 4% today is the same as trying to achieve 8.4% in 2006. In a decade, achieving 4% went from nearly risk-less to very risky.

In the accumulation phase, most investors have a shared objective: growth. The distribution phase, however, is highly personalized based on retirement date, total wealth, lifestyle standards, etc.

So while benchmarks are a fine starting point—and may be perfectly adequate as a risk ballast during the accumulation phase—ultimately, the Barclays Aggregate does not care what your withdrawal needs are.

The Fixed-Income ETF Palette

The good news is that the continued proliferation of ETFs gives investors a full palette of fixed-income sectors to paint with to develop highly customized income portfolios.

In our target income suite at Newfound, we evaluate a universe of 29 fixed-income ETFs, covering the spectrum of:

  • U.S., foreign developed, and emerging market exposures
  • maturities
  • credit risk
  • inflation protection
  • collateralization

One way we find useful to visualize this universe is to plot the exposures based on their expected-forward-dividend yield (net of ETF expenses) and volatility levels.

Source: Yahoo Finance. Analysis by Newfound Research.

We can see that the benefit of incorporating such a large number of exposures is that it allows us to cover nearly the entire yield/volatility spectrum. This allows us to balance available yield opportunities, corresponding risks, and diversification opportunities to develop highly customized portfolios.

Expect Change

We should expect this landscape picture to change dramatically over time. What might be the optimal portfolio today for hitting a 4% yield level might be entirely different six months from now, not only because of changing yield levels, but because of changing diversification opportunities.

Due to this evolving landscape, we advocate for embracing a dynamic, quantitative process that constantly evaluates the investment universe. While at Newfound we embrace several optimization techniques to balance a number of quantitative and fundamental risk factors, for the do-it-yourself investor, this process can be as simple as a standard mean-variance optimization.

Below we have listed the allocations for several sample portfolios generated by our process. Note that, consistent with our view of risk, Newfound’s target income suite aims for distribution yields at spread levels floating above one-year U.S. Treasury rates.

1% 2% 3% 4%
BKLN 4.41% 10.07% 27.21% 22.53%
BND 28.81% 13.19%
GSY 36.53% 42.97% 23.91%
HYD 8.42% 21.45%
HYS 9.73% 19.61%
MINT 35.95%
PCY 8.94% 18.68%
VCIT 26.74% 17.73%
VCSH 16.37%
VMBS 6.74%

Representative portfolios only. For more detailed information about how Newfound manages its target excess yield ETF portfolio suite, please email [email protected] or call 617-531-9773.

The allocations recommended by our process are decidedly off benchmark. As we said earlier, fixed-income benchmarks do not care about our objective. Given our objective to hit a desired income level with minimal volatility, it is not surprising that the resulting portfolio would look entirely different.

Stocks will always be the subject of exciting water-cooler talk. For investors in the distribution phase of their wealth life cycle, however, a focus on developing thoughtful fixed-income portfolios that differ from the traditional benchmark may be critical for achieving their objectives.

Newfound Research LLC has recently held all ETFs referenced. The company is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Founded in August 2008, Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed-income and liquid alternative asset classes. For more information about Newfound Research LLC, call us at 617-531-9773, visit us at www.thinknewfound.com or email us at [email protected]. For a list of relevant disclosures, click here.

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