FMD Capital Management

2 Popular Fixed Income ETFs I Would Never Own

Written by Michael Fabian, April 11th, 2013

ETFs have ushered in an entire realm of investment choices that investors have flocked to over the years, but some of the original offerings have already seem to become relics without a purpose. Let me start by saying that I am firm believer that ETFs are great investment vehicles, and have helped investors and money managers gain exposure to different areas of the market they would have had no hope to touch in recent years. However, as I take a trip back down memory lane to some of the early ETF offerings, namely in the area of fixed income, it makes me shudder to think there is still money allocated to these funds. With just a small amount of research, investors can vastly lower their exposure to interest rates, increase their yield, or add measurable alpha to their portfolio all in one foul swoop.

With every problem there comes a solution, so in this series of articles for each ETF on my “black list”, I will point out both an open end mutual fund and/or newer ETF with a much better value proposition. I will also make clear the comparison of any additional risks investors might be subjecting their capital to if they were to ultimately make a change. There are many considerations to investing, and cost is one that seems to come up quite often, so I also want to be forthright in the underlying expenses of each fund so the cost-benefit can be easily understood.

The two ETFs I want to make mention of are the iShares Total U.S. Bond Market ETF (AGG) and the Vanguard Total Bond ETF (BND). Many are familiar with these funds as they are one stop shops that expose your portfolio to the popular Barclay’s Aggregate Bond Index, which is the benchmark that most all bond funds are measured against. The first reason for my contempt in these ETFs is that your obviously never going to do any better than the benchmark, but often times you do even worse. Whenever the index changes, your securities are rebalanced at typically the worst possible time, and at the worst possible price. In addition, the index is formulated to represent the weighting of the entire U.S. bond market, which in recent years has seen colossal amounts of treasury and agency MBS issuance. In turn, this exposure has pushed the effective duration higher, and yields lower due to the Federal Reserves accommodative polices and endless purchasing programs in each respective sector. Other higher yielding areas of the bond market have simply been muscled out of the index, and with so many investors worried about rising rates, I’m flabbergasted there is still over 30 Billion spread across these two funds. The lonely bright spots in my opinion are ease of use, and low fees, which is a benefit but not enough to outweigh the risks.

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I believe this chart proves that the shear size and breadth of the bond market lends itself to active management, where investors can truly benefit from the expertise of individual security selection. In addition, these funds and their respective managers will change their sector allocation to sidestep the type of risks the index cannot. Even though the core bond options I’ve listed currently carry a similar duration to AGG and BND, in past experiences all of these managers will actively look to reduce duration in anticipation of a rise in interest rates.

With respect to costs, on a percentage basis the increase in expense ratio appears significant, but not when you take a look at the benefit in performance. I would also note that if you were to survey all actively managed bond funds, these expense ratios are not out of the ordinary. In my investing endeavors, I would pay more to get more, and pay more to lose less 100% of the time. The additional risk of this actively managed trio are pretty calculable, as a broad statement all three are assuming more credit exposure than the benchmark. More specifically, they are making investments in non-agency MBS, floating rate, high yield corporate, and emerging market bonds. These sectors are much smaller than the two sectors that dominate the benchmark, and with the fed gobbling up so much new issuance, we have continued to see prices in these areas move higher. In addition, there is often the added benefit of higher yields and improving credit fundamentals due to the improvement in the global economy.

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In the graph above I have charted each fund on a year to date basis. Since interest rates through today are relatively unchanged, its interesting to look at the difference in drawdown and the overall outperformance. If you find yourself with money languishing in either of these two passively managed ETFs, consider taking a more proactive role in making changes to increase your opportunity for better returns. No matter which route you take, I believe your money is better allocated to an alpha creator that directly seeks to outperform these two ETFs and have consistently done so for decades.