Using Duration In Your ETF Selection Process
Below are some general ideas about how you could apply duration in your selection process. The examples are drawn from national muni ETFs. Because Build America Bonds are subject to federal income taxes, the Build America Bond ETFs are also excluded here. These examples are for discussion purposes only and are not intended as a recommendation of a specific course of action for any investor, nor is there any implied endorsement or criticism of the funds used or excluded.
The appropriate duration will vary from one investor to the next, and should be revisited if there is a meaningful change in your situation or in market conditions. These tactical suggestions are not meant to be comprehensive, but to offer a starting point for your own thought process. Depending on your goals, you may be able to take on minimal risk, or your circumstances may force you to take on more risk. Using duration can you help be better informed about the risks you are taking when you make those decisions.
Diversified Asset Allocation: If you are considering adding a municipal bond ETF with a lower duration, it will provide less interest rate volatility, and you may need a larger allocation to provide the needed balance to your equity risk.
If your financial plan provides a recommended asset allocation mix, compare the duration of the fixed-income benchmark used against your proposed ETF. Using a lower-duration ETF than the benchmark could be a less effective diversifier. Conversely, an ETF with a higher duration should bring greater noncorrelating performance than modeled in your plan, and could permit a slight reduction in the percentage allocated to fixed income.
The SPDR S&P 500 ETF (SPY | A-98) is shown as a proxy for equity market exposure. Note how the year-to-date performance of these selected muni ETFs goes up along with duration. Keep in mind that the higher price sensitivity can go both ways—in a rising rate environment, a higher duration ETF would be expected to decline more quickly. But when paired with other asset classes, the ideal is for the portfolio to have an overall lower risk profile.
|Ticker||Fund||Duration||Weighted Credit Quality||YTD Price Change
as of 2/12/16
|SPY||SPDR S&P 500||N/A||-7.16%|
|N/A||Barclays Global Aggregate (as of 2-15-16)||6.62|
|SUB||iShares Short-Term National AMT-Free Muni Bond||2.01||AA||+0.57%|
|MUB||iShares national AMT-Free Muni Bond||6.30||AA-||+1.27%|
|MLN||Market Vectors AMT-Free Long Municipal||10.14||A+||+2.16%|
Asset Preservation, with Income a Secondary Consideration: If you will be holding your muni ETF for a short-to-intermediate time frame, you may prefer to favor a comparable short-to-intermediate duration ETF so as not to take on too much interest rate risk.
If rates move higher before you sell, an ETF with a lower duration would be expected to decline by less than an ETF with a longer duration. Keep in mind that income earned may be able to offset some of the potential decline in market value, but generally, when asset preservation is the primary objective, duration selection should be in line with anticipated liquidity needs.
For example, looking at the Pimco Short Term Municipal Bond ETF (SMMU | C-47), if you needed to sell in one year and rates moved higher by 1%, you would expect your share price to decline by approximately 2%, and to have collected almost 1% in income over the year, for a negative total return for the period. If you were comfortable that you would not be forced into selling in one year, you may be more comfortable with the 2.03 duration of that ETF.
Noninvestment-grade credit exposure should be within the overall portfolio risk tolerance, which most often would be a percentage of the overall fixed-income allocation. (Dividend yield is blank if there is less than 12 months of data available.) (Data from ETF.com Screener.)