In a Weekend Investor article in the Wall Street Journal, the author Joe Light describes how trends in bond ETFs are changing amid the expected rise in interest rates in the near future. ETF, which is an acronym for Exchange Traded Fund, is essentially a portfolio of assets that typically track some underlying index. For instance, if you were to purchase one of the popular SPDR S&P 500 ETF (pronounced “spider”), you’re essentially buying a small piece of every company within the S&P 500 stock index basket. There are many benefits to buying a low-cost ETFs, including the possibility of diversification and liquidity. A good primer on ETFs can be found from the youtube channel of Blackrock, which is an asset management firm and industry leader in ETF investments.
ETFs can offer investors greater liquidity than through investing in individual securities because, while the overall size of the ETF may be large, the size of the holdings of any given asset within the ETF is much smaller. For instance, if someone purchased $1Billion worth of single company, or a small portfolio of companies, and later decided to sell all of their shares at once in what is called a “fire sale,” then the added supply of shares in the market would cause the underlying asset prices to drop. In this case, the investor might have to sell for a significant loss to get his/her money out right away. However, if one bought $1 Billion worth of SPDR “SPY” ETFs based on the S&P 500 and decided to sell the whole ETF at once, the prices of the underlying assets might shrug off the effects. In this case, you may have only invested $2 million in each company (assuming equal weights within the portfolio), which is typically not enough to dramatically affect the supply and price of an asset.
An ETF can cover a range of assets as narrow as a single industry such as oil and gas, or as broad as an entire market, so an investor can essentially choose how diversified their portfolio is. For instance, if you were an investor that had purchased a diversified international equities index fund, but were hoping to also hedge your investments against fluctuations in stock market, one could buy a bond ETF that would be composed of assets like Government Treasury Bonds, Corporate Bonds, or asset backed securities.
While bond portfolios might in normal times make an attractive investment for those wishing to diversify their portfolios, many investors are currently hesitant to touch them due to expectations of a rise in interest rates in the near future, given the U.S. Federal Reserve’s decision to begin to wind down its quantitative easing purchases. So if the artificial demand for bonds created by the FED will soon be lifted, likely causing bond yields to increase and prices to drop, how can a bond investor sensibly make money on these trades? The answer is hedging.
Many companies including Blackrock and WisdomTree Investments have launched plans for hedged bond ETFs that will protect investors from the ever-more-likely drop in the price of bonds. One such ETF is called a zero-duration ETF, which is a portfolio that both goes “long” on bonds (meaning you purchase bonds) while going “short” on certain bonds and derivatives (such as by shorting U.S. treasuries or Treasury futures contracts). In this case, a short is when you borrow a share of an asset, immediately sell it, and then pledge to the lender to return the share at a later date by purchasing another share at (hopefully) a lower price. This “hedging” allows investors to essentially place bets on both sides of the market; if interest rates and bond yields fall, then the investors profit from the rise in the price of their bonds, but if bond yields rise then the investor can offset much of the losses in their bond portfolio by the increased return from their “short” bets.
While there are many benefits to hedging, including in using hedged bond ETFs like the zero-duration ETF, the costs are also larger. Hedges can add to the cost of a portfolio because the investor must purchase instruments such as futures contracts, or place money on margin to short an asset (margin is somewhat like a security deposit; in the case that an investor can’t afford to buy back a share that it borrowed from the broker, the broker gets to keep the margin). If investors invest in high-fee hedged ETFs without looking at the annual management fees, then they might be disappointed in the size of the returns after the wealth managers take a cut. Overall, there’s a price to safety in unstable markets, so investors would be wise to consider all of the investment choices available to them before they let a broker touch their nest eggs.