Author Archives: Scalper1

Rate Hike In The Cards: How Will Bond ETFs React?

With the U.S. economy gaining traction lately on a solid job market and moderate inflation, the chances of an interest rates hike is pretty high. The market is anticipating the first rate hike in nearly a decade at the December 15-16 policy meeting. If this happens and the Fed starts tightening, it will result in higher yields and lower bond prices as both yields and bond prices are inversely related to each other. How Bonds React to Higher Rates? The impact on prices is not the same for all bonds when rates rise. It primarily depends on duration and maturity. Duration is a measure of a fund’s sensitivity to a 1% change in interest rates. The longer the duration, the more sensitive the fund is to the changes in interest rates. This can be explained with the following example: consider a 10-year maturity investment grade corporate bond with duration of 8.4 years and coupon rate of 3.5%. If interest rates go up by 2%, then the bond will lose 15% of its market value. On the other hand, the same investment grade corporate bond with duration of 14.5 years, maturity of 30 years and coupon rate of 4.5% will lose 26% of its value if interest rates are raised by 2%. As a result, bonds having higher duration will experience significant losses when interest rates rise. Below, we have presented three ETFs that have a higher duration and are more vulnerable to an increase in interest rates. PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSEARCA: ZROZ ) This ETF follows the BofA Merrill Lynch Long US Treasury Principal STRIPS index and holds 20 securities in its basket. Both effective maturity and effective duration are 27.28 years. The fund has accumulated $162.3 million in its asset base and trades in average daily volume of 44,000 shares a day. It charges 15 bps in annual fees and lost 0.7% over the past one month. Vanguard Extended Duration Treasury ETF (NYSEARCA: EDV ) This fund seeks to match the performance of the Barclays U.S. Treasury STRIPS 20-30 Year Equal Par Bond Index. The fund holds 73 bonds in total with effective maturity of 25.0 years and average duration of 24.6 years. Expense ratio came in at 0.12%. The product has amassed $368.6 million in its asset base while sees moderate volume of 51,000 shares per day on average. It lost 0.7% over the past one month. iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) This is one of the most popular and liquid ETFs in the long-dated bond space with AUM of over $6.1 billion and average daily volume of more than 8.8 million shares. It tracks the Barclays Capital U.S. 20+ Year Treasury Bond Index, holdings 31 securities in its basket. The fund has average maturity of 26.51 years and effective duration of 17.23 years. It charges 15 bps in annual fees and was down 1.3% over the past one month. Ultra-Short Bond ETFs We also highlight three ultra-short bond ETFs with lower duration and interest rates’ risk. These funds offer investors greater protection against interest rate risk compared to the mid- and long-term counterparts. SPDR Barclays 1-3 Month T-Bill ETF (NYSEARCA: BIL ) This product offers exposure to the short end of the yield curve by tacking the Barclays 1-3 Month U.S. Treasury Bill Index. It holds 10 securities in the basket with average maturity and effective duration of 0.09 years each. The fund has amassed $2.2 billion in its asset base while trades in solid volume of 1.5 million shares. It charges 14 bps in annual fees and delivered flat returns in the past one month. Guggenheim Enhanced Short Duration ETF (NYSEARCA: GSY ) This is an actively managed fund that seeks to maximize income by outperforming the Barclays Capital 1-3 Month U.S. Treasury Bill Index along with preservation of capital and daily liquidity. The fund charges 25 bps in annual fees and has amassed $504.6 million in its asset base. Volume is good as it exchanges about 152,000 shares a day on average. Holding 148 securities in its basket, the ETF has average duration of 0.17 years and average maturity of 1.03 years. GSY was relatively flat in last one-month period. iShares Short Maturity Bond ETF (BATS: NEAR ) This actively managed ETF looks to maximize current income through diversified exposure to short-term bonds such as Treasuries, corporate bonds, asset-backed debt, and commercial mortgage-backed securities. The effective duration of the fund is 0.37 years while average maturity is 0.95 years. The product has accumulated $1.9 billion in AUM and trades in solid volume of 356,000 shares a day. It charges investors 25 bps in fees a year and added 0.14% in the past one month. Conclusion Given that not all bonds behave similarly to the increase in interest rates, investors should understand the impact of higher rates on bonds before investing in them. Notably, short-term bond ETFs are less impacted by higher interest rates. Original Post

Fed Up Of Rate Hike Timing? Stay Invested In REIT-Focused Funds

Comments from key Federal Reserve officials and improving economic data have added fuel to rate hike hopes. In September, hopes of a lift-off had fizzled out as the date for the FOMC meeting approached. However this time, factors that will help in deciding on the rate hike have growing in numbers. Moreover, market volatility is now at a level that should help the cause against the high levels seen in September. Investors may be ‘fed up’ of Fed’s actions or inactions and the effects of both is a story that has been done to death. But we have to remind investors about funds that would be the best buys before ‘Fed ups’ the rate for the first time in a decade, even at the cost of repeating ourselves. Fed Comments Several Fed officials pointed toward a series of rate hikes at a moderate pace. Atlanta Fed President Dennis Lockhart stated that he was “comfortable” with a rate hike “soon.” Cleveland Fed President Loretta Mester said the central bank had not firmed up on a December rate increase. However, Mester added that: “Things are on track.” Fed vice chairman Stanley Fischer mentioned that “some major central banks” could quit the near-zero interest rate policy “in the relatively near future.” New York Fed president William Dudley and St. Louis Fed president James Bullard also made similar comments. According to a Dow Jones report, William Dudley said on Friday that the central bank may approach the goals needed to hike rates, but it still has time to decide on whether or not it will hike rates in December. The timing is data-dependent and Dudley expects to see indications of increasing inflation soon enough. He mentioned that the US economy is in “good shape”, helping the Fed meet the criteria for rate hike in the near future. Separately, James Bullard reportedly said that the central bank may move back to an era of uncertain rate hikes based on meeting-by-meeting basis after the first rate hike. FOMC Minutes Minutes from the Federal Open Market Committee’s (FOMC) meeting in October stated that most officials anticipated that conditions to lift short-term interest rates “could well be met by the time of the next meeting” in December. The Fed is waiting for further improvements in labor market conditions and inflation to touch its target rate of 2% before hiking rates. Fed officials with a hawkish stance also said that further delay in raising rates will show lack of confidence in the economy. Fed officials said volatility in the financial markets has subsided since September. According to them, “the U.S. financial system appeared to have weathered the turbulence in global financial markets without any sign of systemic stress.” Moreover, officials believe that there is “solid underlying momentum” in business and consumer demand, despite a slowdown in third-quarter GDP growth. Economic Data Last week, economic data was inclined toward the positive side. The U.S. Department of Commerce reported in its “second” estimate that the economy grew at a pace of 2.1% in the third quarter, compared to earlier projected growth rate of 1.5%. Also, third quarter’s growth rate came in higher than the consensus estimate of 2% growth. An upward revision in business inventories emerged as the main reason behind the expansion in quarter. Business inventories were revised upward from $56.8 billion reported in “advance” estimate to $90.2 billion. However, third-quarter growth remained below second quarter’s rate of 3.9%. The U.S. Department of Commerce reported that new orders for manufactured durable goods rose by $6.9 billion or 3% in October to $239 billion, significantly beating the consensus estimate of a 1.6% rise. Increase in demand for large, commercial airplanes was mainly behind the gain in October. It was preceded by a 0.8% decline in September. Moreover, the Labor Department reported that jobless claims in the week ending November 21 declined by 12,000 from the previous week to 260,000. According to the Commerce Department, personal income rose $68.1 billion or 0.4% in October, in line with the consensus estimate. It was higher than September’s increase of 0.2%. These strong data added to rate hike possibility. REITs: You Can Actually Buy Them Now Interestingly, we have a contrarian view about what to do with REITs. Many would say that REITs should be offloaded and they are not very wrong given that these thrive in a low rate environment. Low rates imply low borrowing cost for the Real Estate Investment Trusts (REITs) that allow them to purchase or develop real estate. Moreover, REIT stock yields become more attractive when Treasury yields fall (REITs are often treated as bonds because of their high dividend paying nature and therefore, Treasury yields end up playing a significant role in their price movement). Rising interest rates lead to an increase in interest costs as REITs usually look for both fixed and variable rate debt financing to pay back maturing debt, and fund their acquisitions, development and redevelopment activities. Therefore, REITs cannot practically run away from the impact of rate hikes. But the extent of such an impact would depend on the nature of their leases and funding activities. As for the contrarian view, an improving economy will step up REIT activities and thus an increased demand for space. Since supply has been slow with tepid economic recovery in the past, this increase in demand would lead to higher rents and occupancy rates. Also, if rate hike is gradual, REITs will get enough time to adjust. The REIT sector investors in particular should get a boost from a stronger U.S. job market, improving consumer confidence and stable housing recovery. Adjustments with the rate environment would be comparatively easier for sectors with the advantage of pricing power like hotel, storage and apartment REITs that have shorter-term leases. Meanwhile, a NAREIT study shows that out of the 16 periods of significant interest rate rise since 1995, listed equity REIT returns were positive in 12. This implies that REITs actually gather more steam amid rising rates. Moreover, REITs have been proactive in the capital market in recent years. They have opportunistically used the low rate environment to make their finances more flexible, which is encouraging down the line for their operational efficiencies. 3 REIT Funds to Buy On that note, investing in funds focused on REITs would be a prudent move. Below we present 3 funds, which have significant exposure to REITs and carry either a Zacks Mutual Fund Rank #1 (Strong Buy) or Zacks Mutual Fund Rank #2 (Buy). Remember, the goal of the Zacks Mutual Fund Rank is to guide investors to identify potential winners and losers. Unlike most of the fund-rating systems, the Zacks Mutual Fund Rank is not just focused on past performance, but also on the likely future success of the fund. Cohen & Steers Real Estate Securities A (MUTF: CSEIX ) seeks total return. CSEIX invests a large chunk of its assets in common stocks of companies whose operations are related to the real estate domain and REITs. CSEIX is expected to invest not more than 20% of its assets in non-U.S. companies including that from emerging economies. CSEIX currently carries a Zacks Mutual Fund Rank #1. Over year-to-date and 1-year periods, CSEIX has gained 6.7% and 9.3%, respectively. The respective 3- and 5-year annualized returns are 15.4% and 13.6%. CSEIX has an annual expense ratio of 1.21%, which is lower than the category average of 1.29%. T. Rowe Price Real Estate (MUTF: TRREX ) seeks capital appreciation over the long run with growth in current income. TREEX invests a majority of its assets in companies from the real estate domain. TRREX also allocates a notable share of its assets in real estate investment trusts (REITs), including equity REITs and mortgage REITs. The fund may also invest in non-U.S. firms. TRREX currently carries a Zacks Mutual Fund Rank #2. Over year-to-date and 1-year periods, TRREX has gained 4.7% and 7.1%, respectively. The respective 3- and 5-year annualized returns are 13.5% and 12.7%. TRREX has an annual expense ratio of 0.76%, which is lower than the category average of 1.29%. Franklin Real Estate Securities A (MUTF: FREEX ) invests most of its assets in securities of companies that qualify under federal tax law as REITs and in companies that earn at least 50% of their revenues from residential or commercial real estate activities. FREEX currently carries a Zacks Mutual Fund Rank #2. Over year-to-date and 1-year periods, FREEX has gained 2.4% and 4.6%, respectively. The respective 3- and 5-year annualized returns are 12.3% and 12.4%. FREEX has an annual expense ratio of 0.99%, which is lower than the category average of 1.29%. Original Post

There Is No Defense Of Closet Indexing

Closet indexing occurs when a high-fee mutual fund or ETF promises to be able to “beat the market”, charges a fee premium relative to its benchmark and then largely mimics the performance of the benchmark. This is a tremendous problem for investors, because they usually end up paying hefty fees in exchange for empty promises. When I review client portfolios, I find that an alarmingly high number of them hold closet index funds (before I release these demons into the netherworld). I bring this up in response to a piece today on Morningstar titled ” In Defense of Closet Indexers “. The subtitle is “They are no worse (or better) than other forms of active management”. There are two issues here I’d like to highlight: The false dichotomy of “passive” versus “active” creates confusion from the start. The financial industry seems very confused on this subject, thanks to unclear academic literature on the topic. We tend to assign the term “active” to funds that are literally more active. By this definition, Warren Buffett is a “passive” investor, because he doesn’t often change his portfolio. This is obviously ludicrous. The correct definition of passive is a strategy that tries to capture the market return, versus the active investor who tries to be able to beat the market return. But since we all deviate from global cap weighting (the one true benchmark of outstanding financial assets), we are all active investors. In a world of low-fee indexing, this distinction has become increasingly muddled by market commentators. The Morningstar article defends high-fee active management based on a false dichotomy. This debate is not about “active” and “passive”, it is about the efficiency in which we are active. The core of the defense in the article is the fact that four of American Funds’ U.S. stock funds have bested the S&P 500 over the last 15 years. This is true, but none of them have bested the S&P on an after-tax and fee basis in the last 1, 3, 5 or 10 years. In fact, many of those funds have dramatically underperformed after taxes and fees over these periods, as you can see in the figure below (I wasn’t sure which funds he was referencing, but the following six funds are US equity-heavy). So yes, if you had the foresight 15 years ago to pick those funds, then you “beat” the S&P 500, but if you were an investor who bought one of these funds at any time in the last decade, you bought a fund that gave you 95% of the S&P 500 correlation with a lower after-tax and fee return. And given the propensity for investors to chase returns, it’s almost certain that the vast majority of the people who own these funds have not captured that 15-year outperformance. In other words, most of the investors in these funds have invested in a closet index and not benefited from it. (click to enlarge) In general, I agree with the cited academic paper referring to closet index funds as a “gigantic mis-selling phenomenon”. I don’t think we should ban these funds, as the paper asserts, but I do think we need to properly assess this problem so investors can make better-informed decisions. We still siphon way too many billions of dollars into investment firm coffers for no good reason. That’s money that is directly harming your retirement and livelihood. There is no practical defense of this.