The toughest bond market conditions in decades have prompted ETF companies to get creative in developing new products for investors.
The twin terrors of bond investing today are low yields and the threat of a return to more normal interest rates. The answer several exchange-traded fund companies have come up with is the tactical bond ETF, a product that is designed to navigate these complexities.
Tactical bond funds hint at the next phase of growth for an ETF industry that has given investors hundreds of different products to choose from, but little guidance on how to deploy them. Instead of agonizing over the right mix of bond ETFs for your portfolio, you buy a tactical fund that does the job for you by bundling various other funds together.
There's obviously a market for this type of product – several hundred millions of dollars have flowed into tactical bond funds in the past year or so. But one index investing purist isn't buying. "We haven't used them for any clients, and I don't see us recommending them," said Dan Bortolotti, an investment adviser with PWL Capital and the man behind the Canadian Couch Potato blog.
The traditional ETF is an index-tracking device – you get the returns of a target stock or bond index, minus a small fee. Tactical bond ETFs add a layer of human involvement in selecting various index-tracking bond ETFs and advantageously blending them together.
It's this active management that turns off Mr. Bortolotti. He just doesn't believe a crew of portfolio managers with their screens and models can build a bond portfolio that beats a plain vanilla bond ETF. "If there's one thing that the past five years have taught us, it's that interest rates are not predictable. I just don't see the value of putting your fixed income in the hands of someone who is going to make unreliable forecasts."
Tactical bond ETFs are too new to judge on performance, although short-term results have been mixed. What we do know is that these products are at least a bit more expensive to own than the most basic bond ETFs. That's significant at a time when the five-year Government of Canada bond yields less than 1 per cent.
The case for a tactical bond ETF is that they offer a solution for investors baffled about how to handle bonds right now. "You have an environment of very low rates, so you're not getting paid a lot to hold fixed income," said Pat Chiefalo, head of the iShares ETF lineup for Blackrock Canada. "And you're in an environment where you might be at a crossroads where, potentially, rates are going higher. If you look over the past 20, 30 years, that is a unique challenge for investors."
Mr. Chiefalo said he's seen advisers trying to navigate through this landscape by scaling back client exposure to bonds and moving money into dividend stocks. Another approach has been to lean heavily on high-yield bonds, issued by companies with less-than-ideal financials. Both approaches add risk to a portfolio because they reduce exposure to the government and high-grade corporate bonds that offer stability during stock-market corrections.
As an alternative, let's look at an example of the tactical bond. The iShares Short Term Strategic Fixed Income ETF (XSI) was introduced in January as a way for investors and advisers to stay in bonds while generating a competitive yield and managing risk. The fund currently holds six iShares products covering floating rate bonds, investment-grade and high-yield corporate bonds, emerging-market bonds and convertible bonds.
XSI's after-fee yield to maturity is about 3 per cent, which compares to about 1.7 per cent for the iShares Canadian Universe Bond Index ETF (XBB). This latter ETF is a popular way to get broad exposure to bonds, but it has risk. Specifically, it has a duration of 7.4 years, which is to say that if interest rates went up 1 per cent, this ETF would fall 7.4 per cent in price (you'd still get paid interest, of course).
The duration for XSI is 3.6 years, so it's basically half as vulnerable to a rate rise as XBB. But it has other risks investors should know about. High-yield bonds account for about one-third of the portfolio – they behave much like stocks in stressful times for financial markets. Expect the same from emerging market bonds, which make up about 6.5 per cent. Government bonds – best in the bond universe if stocks are crashing and worst if interest rates are rising – have a weighting of 17 per cent.
Another point to be aware of is that XSI is positioned for an improving economy and rising rates. If we get a surprise downturn that send rates lower, you won't get much juice out of this ETF until the managers recalibrate (rebalancing is done quarterly).
Other tactical bond ETFs have decidedly different mixes, a point that highlights how these products put you in the hands of the people managing them. The popular PowerShares Tactical Bond ETF (PTB) has half its assets in a conservative laddered corporate bond ETF and one-third in an aggressive long-term bond ETF.
The Purpose Total Return Bond Fund (PBD) has roughly two-thirds of its assets in high yield and the rest in mid-term corporate and government bonds. This fund also highlights the pricing issue with tactical bond ETFs – expect to pay the fees of the underlying ETFs, plus some level of additional management costs. The management expense ratio on this fund comes in at 1.03 per cent, with fees for the underlying funds totalling 0.53 per cent.
If you decide to use a tactical bond ETF, make sure it's one with a mix of funds that makes sense to you and a reasonable cost. Figure on complementing a basic bond ETF with a tactical fund, not replacing it.
Mr. Bortolotti's suggestion if you're nervous about how rising rates will affect your bond ETFs: Buy a short-term bond fund holding bonds maturing in five years or less. They won't be impervious to rising rates, but they will hold up better than the mix of bonds you'll find in a fund such as XBB and its competitors. To compare what's available in short-term bond ETFs, check out the bond instalment of my 2015 ETF Buyers' Guide.
Time for new tactics?
The ETF business has been issuing a lot of tactical bond funds lately as a way of helping investors ready their portfolios for any bond market turbulence ahead. Tactical funds hold various underlying bond ETFs that are chosen and weighted by either computer models or managers to suit the market conditions at hand. Here's an overview of some these funds.