Posts Tagged ‘Bond Index’

2 Popular Minimum Volatility ETF Strategies

Tuesday, August 21st, 2012

by Del Stafford, iShares

By now, you’ve probably heard about the benefits of a minimum volatility (or, “min vol”) strategy and the ETFs that seek to deliver it, but you might still be wondering how to use these funds in a portfolio. One common misconception is that min vol ETFs are a tool designed for volatile markets specifically, but this simply isn’t the case. In fact, the two minimum volatility ETF strategies we see our clients using most often are both strategic, long-term plays that have nothing to do with current market volatility. These two strategies are: 1) lowering overall portfolio risk or 2) increasing allocation to equities without increasing overall portfolio risk.

Lower overall portfolio risk
Investors who are trying lower their overall portfolio risk can simply replace their existing market capitalization based equity investment with the corresponding minimum volatility ETF. For example, let’s say a client’s portfolio consists of 60% equity and 40% fixed income. Let’s use the MSCI USA Index to represent “equity” and the Barclays US Aggregate Bond Index to represent “fixed income”. The client would replace the 60% allocation to the MSCI USA Index with a 60% allocation to the MSCI USA Minimum Volatility Index.

This strategy would result in a ~20% reduction in portfolio risk since inception of the analysis (June 2008) and an even greater reduction in risk in the nearer term (see below).

Increase allocation to equities without increasing overall portfolio risk
Like the example above, an investor looking to employ this strategy would start by replacing their existing market capitalization based equity investment with the corresponding minimum volatility ETF, but then they would also increase their allocation to the minimum volatility ETF while decreasing their allocation to fixed income. After replacing the MSCI USA Index with the MSCI USA Minimum Volatility Index, the investor would increase their allocation to the MSCI USA Minimum Volatility Index and decrease their allocation to the Barclays US Agg Bond Index until the total portfolio risk reaches the level they desire. For example, they may seek a level of portfolio risk that is just below the since inception risk of the Original Portfolio, which is 12.15%.

This strategy allows the investor to increase their allocation to equity by 17% while obtaining a consistently lower level of risk than the Original Portfolio (see below).

While there are certainly other ways to employ minimum volatility ETFs in a portfolio, our team has found that these two strategies are the most commonly used among our clients.

Source: Markov Processes International (MPI)

Del Stafford, CFA is the iShares Head of Product & Investment Consulting and a regular contributor to the iShares Blog. You can find more of his posts here.



The iShares Minimum Volatility Funds may experience more than minimum volatility as there is no guarantee that the underlying index’s strategy of seeking to lower volatility will be successful.

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Bond ETF Idea: Deconstructing the Agg

Friday, June 8th, 2012

 

by Matt Tucker, iShares

Its building block time again! I recently wrote a post about different ways that ETFs can help investors meet their income objectives. The two options were: 1) “No assembly required,” through a pre-packaged ETF of ETFs such as IYLD (the iShares Morningstar Multi-Asset Income Index Fund), and 2) “DIY,” using individual ETFs as building blocks to construct a customized portfolio. My main point was that a pre-packaged solution can be a great option for investors who don’t have the time, expertise, or inclination to create and continuously manage a portfolio on their own.

For investors who don’t have those challenges, a DIY approach to managing a fixed income portfolio may be the way to go. Each of our fixed income iShares ETFs is essentially its own building block, and they can be combined in a variety of ways to create a wide range of fixed income portfolios.

Why take this approach? For one thing, within the “fixed income” category, there are a variety of sectors that have very different risk and return characteristics. And since fixed income investors can have very distinct goals, meeting portfolio objectives typically requires more than a one-size-fits-all approach. For example, a portfolio that’s designed to generate income should look very different from one that has a goal of delivering alpha.

One strategy we are always talking about with clients is taking a broad benchmark like the Barclays US Aggregate Bond Index (“the Agg”), buying ETFs that represent its various sectors, then tilting exposures based on market factors, sentiment, and/or research calls. It’s kind of like constructing the toy vehicle shown on the building block box, and then giving it your own custom modifications.

The reason investors typically start with the Agg is because it’s generally considered to be a good representation of the broad US fixed income market. It combines six unique fixed income sectors – Treasuries, Agencies, Credit, Mortgage Backed Securities (MBS), Commercial Mortgage Backed Securities (CMBS) and Asset Backed Securities (ABS). As you can see below, each sector has a unique risk and return profile:

Components of the Aggregate – Relationship Between Yield, Duration & Credit Risk

Fixed income ETFs are a great tool for implementing this kind of strategy because, in addition to typically being low cost and tax efficient, there’s such a breadth and depth of products available today. For example, an investor might start with a strategic allocation that mimics the breakdown of the Agg (which is updated on a regular basis here), using ETFs to represent each sector. Then, they can customize based on their specific objectives. If income is the goal, they might lighten up on the lower yielding sectors in order to overweight those that are yielding more. In fact, investors can use our free Fixed Income Portfolio Builder tool (demo here) to explore fixed income portfolios that have the same duration characteristics as the Agg, but with the potential for higher yield. Investors can also make adjustments based on how much credit or duration risk they’re willing to take, or make tactical plays based on the current market environment. The idea is that the fine-tuning is in the investor’s hands.

You have all the blocks, what do you want to build?

Matt Tucker, CFA is the iShares Head of Fixed Income Strategy and a regular contributor to the iShares Blog. You can find more of his posts here.

Source: BlackRock, as of March 2012. Tickers shown in the table are related iShares ETFs that correspond to each index. Indexes used are: iBoxx $ Liquid High Yield Index (HYG), JPMorgan EMBI Global Core Index (EMB), iBoxx $ Liquid Investment Grade Index (LQD), S&P Nat’l AMT-Free Muni Bond Index (MUB), Barclays Capital U.S. Aggregate Bond Index (AGG), Barclays Capital U.S. 1-3 Year Credit Bond Index (CSJ), Barclays Capital U.S. 3-7 Year Treasury Bond Index (IEI), S&P Short Term Nat’l AMT-Free Muni Bond Index (SUB), Barclays Capital U.S. 1-3 Year Treasury Bond Index (SHY), BofA Merrill Lynch 10+ Year US Corporate & Yankees Index (CLY), Barclays Capital Emerging Markets Broad Local Currency Bond Index (LEMB), Barclays Capital U.S. Corporate Aaa – A Capped Index (QLTA). Yield represents the average YTM; Duration represents the effective duration

Index returns are for illustrative purposes only and do not represent actual iShares Fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. For actual iShares Fund performance, please visit www.iShares.com or request a prospectus by calling 1-800-iShares (1-800-474-2737).

Bonds and bond funds will decrease in value as interest rates rise.
Transactions in shares of the iShares Funds will result in brokerage commissions and will generate tax consequences. iShares Funds are obliged to distribute portfolio gains to shareholders.

 

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The Economy and Bond Market Radar (April 2, 2012)

Sunday, April 1st, 2012

The Economy and Bond Market Radar (April 2, 2012)

Time to Pay the Piper

If you haven’t filed your 2012 federal income taxes yet, the clock is ticking. Beginning Monday, you will only have 11 business days to get them in by the filing deadline of April 17, 2012.

Like many nationwide debates, Americans are nearly split down the middle when it comes to taxes. Recent data from Gallup shows 50 percent of Americans believe federal taxes are too high while 43 percent believe they’re about right. Note: the responses are “about right” and “too high;” I don’t believe there are many in the “should be higher” camp. However, after 11 years of the Bush Tax Cuts, it looks like America’s tax rate structure will shift upwards next year. Five of the six tax brackets will increase with the largest earners paying nearly 40, up from 35 percent currently.

One way investors can offset higher tax rates is through municipal bonds. In general, interest generated from municipal bonds is exempt from all federal income taxes and some state and local taxes (depending on your state).

While municipal bonds carry a greater amount of risk than Treasury bonds, tax advantages and higher yields make them extremely attractive to Treasuries on a relative basis. The yield on government debt is currently in the doldrums just above 3 percent while the yield on the Bond Buyer 40 Index of munis is above 4 percent.

10-Year Government Bond Yields

This gap gets even greater when you consider tax exempt income. The tax equivalent yield on a taxable investment (such as U.S. Treasuries) would need to be more than 6.5 percent in order to outpace the muni bond index cited above. This means the yield on U.S. Treasuries needs to roughly double from its current level in order to be attractive to munis on a relative basis.

If you’re one of those investors writing Uncle Sam a big check this year, you should consider adding tax-free bond funds to your portfolio. Explore our Near-Term Tax Free Fund (NEARX) and Tax Free Fund (USUTX).  However, investments and tax planning is complicated and each investor’s situation is unique—you should consult a tax advisor to determine whether or not muni bonds are right for you.

This information does not constitute tax advice and is provided for informational purposes only. Please consider speaking with a legal or a tax adviser regarding your individual situation.

Strengths

  • February durable goods orders in the U.S. rose 2.2 percent, bouncing back after a weak January.
  • German unemployment fell to 6.7 percent in March and to the lowest level since reunification in 1990.
  • Japanese retail sales rose 3.5 percent in February, well ahead of expectations and the best growth since August 2010.

Weaknesses

  • With rising gas prices lifting inflation concerns and dragging down future expectations, the Consumer Confidence Index fell in March.
  • Pending home sales were expected to increase in February but data released this week showed a decline.
  • Initial jobless claims edged higher this week but nothing too concerning just yet.

Opportunities

  • Bonds have staged a rally the past couple of weeks as investors reassessed the global growth outlook. As long as China is comfortable with slower growth, that trend appears likely to continue.

Threats

  • Rising oil and gasoline prices combined with liquidity implications of global easing may raise the prospect of reappearance of higher inflation going forward.

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Bond ETF Idea: Commercial Mortgage Backed Securities

Tuesday, March 6th, 2012

by Matt Tucker, Managing Director, Fixed Income,  iShares

ABS, MBS, CMBS.  Navigating your way around the various fixed income sectors can sometimes feel like a bowl of alphabet soup.  And with the proliferation of fixed income ETFs giving investors more ways than ever to slice and dice the bond market, now’s a great time to brush up on your acronyms.

Take, for example, commercial mortgage-backed securities (CMBS).  CMBS are fixed income securities that are backed by loans on things like office buildings, retail properties, and hotels.  The sector currently represents about 2% of the US fixed income market.

For investors who have a positive view on the commercial real estate market, CMBS are a way to gain exposure with less risk than real estate investment trusts (REITS).  Since its inception six years ago, the Dow Jones US REIT Index has experienced volatility of 30.1% and a return of 2.6%, whereas the Barclays Capital US CMBS Index experienced a volatility of 13.3% and a return of 6.63% during the same timeframe.  Keep in mind that REITS are equity securities, whereas CMBS are debt securities.

CMBS also have a compelling income component – compared to sectors that have a similar duration (a measure of bond risk), investment grade CMBS are currently offering a higher yield.  Note that in the chart below, CMBS is represented by the Barclays Capital US CMBS Index, which only includes investment grade bonds – there are no subprime bonds in the index.

Fixed Income Sector Comparison

With the recent launch of the iShares Barclays CMBS Bond Fund (NYSE Arca: CMBS), the first ETF dedicated solely to CMBS, investors now have the ability to gain diversified access to this sector in a single trade.  We expect to see clients using this fund in a few different ways.  One idea: if the investor prefers an overweight to CMBS, they can use it to complement a diversified bond index fund (such as the iShares Barclays Aggregate Bond Fund; NYSE Arca: AGG).  Or they may use it in conjunction with other bond index funds to build a customized fixed income portfolio.

 

Source: Bloomberg

Chart Source: Barclays Capital and iBoxx as of 2/21/2012. Past performance does not guarantee future results.  Fixed income sectors are represented by the following indexes –   Barclays Capital U.S. CMBS (ERISA Eligible) Index, Barclays Capital U.S. Agency Index, Barclays Capital 3-7 Year US Treasury Index, Barclays Capital U.S. MBS Index, Barclays Capital Intermediate U.S. Credit Index, iBoxx $ Liquid High Yield Corporate Bond Index, Barclays Capital U.S. Aggregate Index

Bonds and bond funds generally decrease in value as interest rates rise. In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility. Commercial mortgage-backed securities (“CMBS”) represent interests in “pools” of commercial mortgages and are subject to credit, prepayment and extension risk, and therefore react differently to changes in interest rates than other bonds. Small movements in interest rates may quickly and significantly reduce the value of CMBS. Diversification may not protect against market risk.

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A Look Back at 2011′s Calls (Koesterich)

Tuesday, January 3rd, 2012

Last December, I shared my economic forecast for 2011, along with a series of investment calls. Nearly every Monday since then, I’ve been highlighting certain asset classes and market sectors in my weekly call posts.

So, how have my calls performed? All in all, most of my views were reasonably right. But, as I explain in my recent Market Perspectives piece, I did get some things wrong.

Back in December 2010, I expected last year to be characterized by anemic growth in most developed markets, stubbornly high inflation in emerging markets and lots of market volatility.

As such, I advocated overweighting equities versus bonds, overweighting developed markets (including the United States) versus emerging markets and maintaining a strategic allocation to commodities. I also was a big fan of overweighting global mega caps versus other market segments. On the fixed-income side, I favored underweighting Treasury bonds, and overweighting investment grade and municipal bonds.

Among the calls I got right, the United States did outperform the rest of the world last year and emerging markets did underperform developed markets. In addition, a broad index of commodities outperformed equities, mega caps outperformed an all-cap index and municipal bonds outperformed other bonds.

My calls to overweight energy and to underweight European banks also were right on the mark. By year’s end, investment grade returns were also outperforming – albeit narrowly — the Barclays Aggregate Bond Index.

On the other hand, I got the stock/bond call wrong as equities dramatically underperformed bonds last year (though I’m still a fan of stocks in the long term). My Treasury call was also dead wrong. Amid slower-than-expected global growth and extreme risk aversion, investors turned to Treasuries in 2011, believing they represented the only real safe haven asset. This was true even after the August downgrade of US debt. At the same time, the timing was off for my call to overweight Australia.

As for my forecasts about the global economy in general, we finished 2011 somewhere between my baseline prediction of slow-but-positive growth and a double-dip recession. This was thanks to a number of unexpected events that acted as additional drags on an already weak economy. In 2012, I expect the slow growth to continue, but there’s always the chance of unexpected events once again.

Source: Bloomberg

 

Bonds and bond funds will decrease in value as interest rates rise.

In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country may be subject to higher volatility.

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The Argument for Stocks & A Region to Consider (Koesterich)

Wednesday, December 21st, 2011

by Russ Koesterich, Chief Investment Strategist, iShares

“Why own stocks in the first place?” Many investors are asking this question in light of the long-term stagnation in global equity markets, recent market volatility and the surprising outperformance by bonds in 2011.

This year so far, US large caps are down around 1% and a broad benchmark of global stocks is down around 10%. At the same time, bonds — as measured by the Barclays Capital US Aggregate Bond Index – are up around 7%.

Despite equities’ poor performance year-to-date, there is a clear long-term case for holding stocks. The argument largely comes down to valuation. As I’ve mentioned in the past, both US and global equities are trading well below their historic averages. In the United States, the S&P 500 is trading at 12.3x trailing earnings. Going back to 1954, this is in the bottom quintile, or lower 20%, of valuation levels.

More importantly, valuations look even cheaper when compared to bonds. A common comparison between stocks and bonds is to look at the earnings yield on stocks — measured by the earnings of an index divided by the price — versus the yield on a bond index. Given that Treasury yields are arguably distorted by the Fed’s quantitative easing program, let’s look at the yield on an index of investment grade bonds. Today, Moody’s BAA Index has a yield of 5.16%, while the earnings yield on the S&P 500 is around 2.5% more. In September, this differential reached 3.1%, the highest level since 1958.

It’s relatively rare that equities yield this much above bonds. Looking at data back to 1954, there were only around 60 months when the spread was this large in favor of equities. This also happened in the mid-1950s, late 1974 and1978. In retrospect, all of these periods represented very attractive long-term entry points to buy stocks.

Today, market conditions are obviously different. Fiscal problems in the United States and Europe are proving difficult to overcome and are almost certain to crop up again in 2012. Of course, one could argue that stocks are cheap now because of a loss of confidence in equities (this was the case in the late 1970s). But even after adjusting for today’s weak consumer confidence, equities still look extremely cheap relative to bonds.

Historically, there has been a tight relationship between consumer confidence and the yield spread between equities and bonds. Since 1991, the level of consumer confidence has explained roughly a third of the variation in the yield spread. When confidence is higher, equity valuations tend to be higher, pushing equities’ yield down relative to bonds. The opposite happens when confidence is low. At today’s yield spread and consumer confidence levels, you would expect large-cap US stocks to be trading at roughly 18x trailing earnings rather than 12.5.

For these reasons, I’m continuing to advocate an overweight to equities, especially for long-term investors concerned with maintaining purchasing power. My preferred way to try to capture this opportunity is through a position in global mega-caps with high dividends (possible iShares solutions: OEF, IOO, DVY, IDV and HDV).

Call #2: Overweight Latin America

I already hold an overweight view of Brazilian equities and am closely watching stocks in Chile. Now, as other parts of Latin America, including Mexico, are also looking attractive I’m advocating an overweight view of Latin American equities in general.

Next year, I expect Latin America to post better relative growth than other parts of the world, including other emerging markets outside of Asia. In addition, while inflation was a serious problem in Latin America last year, inflation in the region is now decelerating. Brazilian inflation, for instance, is still above the Central Bank’s target, but it has fallen to 6.6% today from 7.3% in September.

One potential way to access Latin America is through the iShares S&P Latin American 40 Index Fund, the ILF.

Source: Bloomberg

Author is long DVY and IOO

International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country and narrowly focused investments typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise.

Past performance is not indicative of future results.

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Myth vs Reality in the Hunt for Fixed Income Alpha (Tucker)

Thursday, December 8th, 2011

In the past few decades indexing has increased in popularity among investors. Most of the growth has come in liquid, developed markets such as US equities. The conventional wisdom has been that these markets are too efficient to provide consistent opportunities for active management and the creation of alpha, so a low-cost indexing approach may make more sense.

This same conventional wisdom has led many investors to continue to predominately use active mutual funds in less efficient markets such as fixed income. The theory is that fixed income markets are more opaque, resulting in information asymmetry between investors, and a skilled active manager can use this asymmetry to their advantage to consistently outperform the market.

That’s the theory. But what does the evidence say?

  • Year-to-date through the end of September, 95% of active intermediate bond mutual funds have underperformed relative to the Barclays Capital U.S. Aggregate Bond Index, the common benchmark for the Morningstar US intermediate term bond category. Over the past 10 years through the end of September, 68% of active intermediate bond funds have underperformed, according to data from BlackRock and Morningstar.
  • For active fund managers who do outperform in any single year, it has been very difficult for them to repeat and outperform again the next year. This graphic illustrates this difficulty. Because investors cannot directly invest in an index, the analysis below compares the active intermediate bond mutual funds to the iShares Barclays Aggregate Bond Fund (AGG), which seeks to track the Barclays Capital U.S. Aggregate Bond Index. Over the last 5 years, only 2% of active intermediate bond mutual funds were able to consistently outperform AGG 3 years in a row:
Source: BlackRock, Morningstar. Five-year period ended September 30. (Please see footnote 1)

So what gives? If the fixed income market is less efficient, shouldn’t that make it more fertile ground for alpha generation? The theory is certainly plausible, but it ignores three key points that investors should keep in mind:

  1. The market inefficiencies that lead many to assume that active management would be more successful in fixed income are the same forces that make it more difficult to capture alpha. In a less efficient market liquidity is harder to come by, price transparency is lower and transaction costs are higher. This creates a higher hurdle for fund managers to overcome because there is more friction incurred in implementing strategies, and it makes the consistent production of alpha that much more difficult.
  2. Even if there is the opportunity to create alpha, there is no guarantee that fund managers will make the right moves to take advantage of it. Every opportunity for alpha creation is also an opportunity for alpha destruction. The creation of alpha is driven not only by opportunity, but also by the combination of opportunity and skill. Active management skill is difficult to create and identify. While many investors understand this idea as it applies to equities, it also applies to less efficient markets such as fixed income.
  3. As I explained in my blog last week, the pursuit of alpha involves taking on risk. Many bond fund managers who create alpha do so at the cost of higher return volatility, resulting in less total return per unit of risk than their benchmark. For the fixed income portion of an investor’s portfolio, if safety and stability are the objectives, there can be a conflict between the investor’s goals and the variable performance of the active fund.

There are fund managers who do produce fixed income alpha. But much of that alpha can be eaten up by fees and transaction costs, and those who do produce alpha may have difficulty doing so repeatedly. As in other markets, indexing with ETFs in fixed income offers investors a way to obtain targeted market exposure in a vehicle that has low management fees, low transaction costs, and more liquid access than most other fixed income options.

Footnote 1: Sources: BlackRock®, Morningstar. Five-year period ending 9/30/11. All figures are net of fees. Active mutual funds are based on Morningstar’s US intermediate term bond category.  Percentages are survivorship-adjusted and reflect the fund universe that existed at the start of the analysis period (e.g., the analysis includes funds that existed at the beginning of the analysis period but are no longer available due to fund mergers or liquidations over the analysis period). Analysis is based on the oldest share class of active open-end mutual funds to avoid double-counting of multiple share classes. Performance could have been positive or negative for both active funds and iShares ETFs during the time period. Past performance does not guarantee future results.

Bonds and bond funds will decrease in value as interest rates rise.

Buying and selling shares of ETFs will result in brokerage commissions. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.

Past performance is not indicative of future results.

Copyright © iShares

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The Paradox of Active Fixed Income Management (Tucker)

Tuesday, December 6th, 2011

by Matt Tucker, iShares

Lately, I have been fielding a lot of questions from investors who have been disappointed with the performance of some of their fixed income investments. The basic story is always the same. The investor built a diversified, multi-asset class portfolio. The investor included fixed income in the portfolio to provide diversification from riskier asset classes such as equities and commodities. But now the investor is unhappy with their portfolio’s performance.

Why? On the surface, it appears they did everything “right.” The fixed income holdings were meant to provide an anchor in the portfolio and some stability in uncertain times. As we know, this year markets have been highly volatile, Treasury yields have declined, and most fixed income asset classes have had strong performance in 2011.

So, why are investors not getting the performance they expected from their fixed income holdings? One reason may be that many investors use active mutual funds for their fixed income exposure. A staggering 95% of active intermediate bond funds have underperformed year-to-date relative to the Barclays Capital US Aggregate Bond Index, the common benchmark for the Morningstar US intermediate term bond category, according to data from BlackRock and Morningstar as of September 30, 2011.

But Morningstar data as of September 30 shows it’s not just a 2011 phenomenon — over the past 10 years, 68% of active intermediate bond mutual funds have underperformed.

A lot has been written in the active vs. passive debate, and I will address that topic in a future blog. Today, I want to focus on what I see as the troubling issue here: the conflict between an investor’s goal with their fixed income investment and the strategies employed by many active fund managers.

As a group, active fund mangers look to add yield to create outperformance. The yield that is added typically comes from lower quality, higher risk securities. But these higher risk securities tend to underperform in market dislocations when investors sell riskier investments and move to Treasuries and other more conservative asset classes.

The chart below helps to illustrate this dynamic. It shows the 3-year correlations for the Barclays Capital US Aggregate Bond Index versus a number of other markets. As you can see, the correlation was low or negative to all of the riskier asset classes.

The chart also shows the correlation of the average Intermediate term active bond fund in the same period. Their correlation versus these same indices was positive in every case. If you looked at a time series of this data you would see that the active fund correlations to equity and commodity market performance actually increased when markets sold off.

(Please see footnote 1)

This shows that at exactly the moment that an investor was faced with a declining equity market and was likely looking to fixed income for stability, their active fund’s alpha turned negative. This is what I refer to as the Paradox of Active Management. The strategies employed by many active fund managers are designed to add yield when markets are calm or improving, but it can often lead to underperformance when markets dislocate and riskier asset classes sell off.

This is counter to the role that many investors expect fixed income to play. They want their fixed income investment to be MORE stable when markets dislocate, not less. But many investors continue to invest this way.

The question investors should ask themselves is not whether active or passive is better — it’s what role they want fixed income to play in their portfolio. Invest in fixed income asset classes that are expected to perform in-line with that role, in up and down markets.

If you want lower risk fixed income exposure, consider US Treasuries. If you want more diversified investment grade exposure, consider the iShares Barclays Aggregate Bond Fund, AGG. If you want additional yield in return for taking on more credit risk, then buy high yield. But make each decision with awareness of the relative risks and rewards. Don’t blindly believe all fixed income is the same.

This is exactly what the fixed income ETF was designed for — to provide investors with a vehicle they could use to tailor their fixed income exposure and customize risk. It is designed to give investors complete transparency into what they own, and what they don’t own — in short, to avoid the Paradox.

Footnote 1. Morningstar Direct and MPI Stylus, as of 9/30/11. Correlation based on weekly returns. Correlation refers to the degree to which two securities, on average, move together.  A +1 correlation implies they move in lockstep while -1 implies they move in opposite directions. Intermediate Term Bond Average includes actively managed mutual funds in this Morningstar category.  Percentages are survivorship-adjusted and reflect the fund universe that existed at the start of the analysis period (e.g., the analysis includes funds that existed at the beginning of the analysis period but are no longer available due to fund mergers or liquidations over the analysis period). Analysis is based on the oldest share class of active open-end mutual funds to avoid double-counting of multiple share classes. Index returns are for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Bonds and bond funds will decrease in value as interest rates rise. Diversification and asset allocation may not protect against market risk.

Past performance is not indicative of future results.

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It Was An Ugly One (Ronalds)

Thursday, October 13th, 2011

October 12, 2011

By Scott Ronald, Steadyhand Funds

In preparing our Quarterly Report, I compiled some numbers that speak for themselves:

  • Global stock markets had their worst quarter since Q4 2008
  • Greece was down 42%. Italy, France and Germany were all down 25%. Canada was down 12%. Japan was down 11% (all in local currency terms)
  • Almost every major European market has a P/E below 10 and dividend yields are commonly north of 4%
  • The loonie hit $1.06 US in July and ended the quarter at $0.95
  • Oil fell 17%
  • Base metals fell by more than 20%
  • The Government of Canada 10-year bond yield dropped from 3.1% to 2.1%
  • The US Treasury 10-year bond yield dropped from 3.2% to 1.9%
  • The DEX Universe Bond Index was up 5.1% – its highest quarterly return since 1996
  • North American sovereign bond yields are at levels not seen since the 1940s

For stock investors, it was an ugly quarter. Bond investors, on the other hand, had a heyday. Looking ahead, it seems pretty evident where the opportunities lie. Hint: it’s not government bonds.

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Clearing Up Corporate Vs. Credit Bonds (Matt Tucker)

Friday, August 26th, 2011

by Matt Tucker, CFA, iShares

When talking with investors, I often hear the terms “corporate” and “credit” used interchangeably to describe a certain segment of the bond market. But while these designations are often lumped together, they actually refer to two different types of bonds.

To understand the difference, think about the stock market. When you buy a common stock, you’re buying an ownership stake in a corporation. Many of these same corporations, regardless of where they are headquartered, issue debt in US dollars, and this debt is categorized as “corporate.” Easy enough. Where it gets tricky is that there are a number of other types of entities that also issue USD denominated debt.  The term “credit” captures these other issuers, along with the debt of corporations.

To help us understand the distinction, let’s examine the Barclays Capital U.S. Credit Bond Index, the most common benchmark used to measure the US credit bond market.  Originally this index was corporate-only, as almost all the issuers included in it were corporations that came to the US bond market to raise money.

Over the last decade, however, we increasingly saw other types of entities (think foreign agencies and authorities, for instance) issue bonds in US dollars to lower their funding costs and broaden their investor base.

In June 2000, the index was changed from “Corporate” to “Credit” in order to more accurately reflect the evolution of the US bond market. As you can see from the graph below, about 80% of the credit index is now corporate issuers, with the remaining 20% issued by other types of borrowers. In general, currency and market of issuance, rather than where an issuer is from, determine whether bonds are included in US credit indices.

Let’s take a closer look at the type of issuers included in the Barclays Capital U.S. Credit Bond Index:

  1. Foreign Agencies – Bonds issued by agencies that are owned or guaranteed by a single government.  Similar to Fannie Mae and Freddie Mac, these agencies receive government support to fulfill a social or financial mission of the government. Petrobras, the Brazilian state owned oil company, falls into this category.
  2. Foreign Local Authorities– Foreign municipalities, like the Canadian provinces of Ontario and Quebec, issue bonds to access the large pool of US investors.
  3. Sovereigns – Foreign governments (think Brazil, Mexico and Italy, for instance,) tap the US bond market.
  4. Supranational Agencies – Agencies that are sponsored by more than one central government.  Bonds from these agencies typically have AAA credit ratings, as the bonds are backed by multiple government guarantees. For example the Asian Development Bank, which finances development projects in Asia, is sponsored by 67 different countries.
  5. Taxable Municipals – These are taxable bonds issued by municipalities.  The issuance of these bonds increased during 2009 to 2010 as more state and local governments borrowed money under the Build America Bond program, part of the American Recovery and Reinvestment Act of 2009.

Corporate or credit – what’s the right choice for an investor?  It all depends on what kind of exposure they want.   Some investors prefer corporate debt because they want exposure that better matches up to their equity portfolio, or perhaps they have a market view that focuses on corporate debt specifically.  Other investors may prefer credit as it is a larger, more diversified sector and more fully captures the US bond market. Remember that corporate bonds are included in credit indexes, and their returns are historically highly correlated.  If an investor is indifferent between the two, then they should focus on other factors such as the liquidity, cost, and transparency of the investment vehicles they are evaluating.

1: Source Barclays Capital as of 6/30/2011

Indexes are unmanaged and one cannot invest directly in an index. Index constituents are subject to change.

Bonds and bond funds will decrease in value as interest rates rise.

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