Nobody should invest in bond exchange traded funds without understanding that when interest rates increase, the bond’s price declines. With significant improvements in the economy and unemployment rate, the Federal Reserve is expected to raise rates before 2015 ends. This will affect securities across the entire bond market.
So, what is a bond ETF investor to do? A new exchange traded fund from ETF Managers Group seeks to help investors hedge rising interest rates by using a concept called negative duration that actually creates price appreciation when interest rates advance.
Sit Rising Rate ETF (RISE) holds a portfolio of futures and options contracts weighted to achieve a targeted negative 10-year average effective portfolio duration. Because it holds futures, the ETF is structured as a commodity pool.
Sam Masucci, founder and chief executive of ETF Managers Group, said the ETF should be used as a hedge, or insurance, to protect a bond portfolio from interest-rate volatility. “A small allocation of 10% to 20% in RISE can significantly reduce the interest rate risk within a bond portfolio.”
Duration calculates a bond’s sensitivity to interest-rate volatility. It measures how much the price of a bond is expected to fall when interest rates rise 1% — and rise when rates fall 1%. The longer the duration, the greater the interest rate risk. Negative duration determines how much the price will go up when rates rise. RISE tries to get a 10-to-1 ratio. So if rates rise 1%, the price should go up about 10%.
Bryce Doty, the senior fixed-income portfolio manager at Sit Investment Associates, manages the ETF based on the Minneapolis firm’s strategy.
Where RISE Fits In
Doty said an investor with a bond portfolio with an average duration of four years might choose to sell 20% of the portfolio and invest that money in the negative 10-year duration ETF. This cuts the interest rate risk by almost 70%.
The ETF achieves this effect by holding only four positions. Focused on the risk to short-term rates, 85% of the ETF’s portfolio is in short positions tied to 2-year U.S. Treasury and 5-year U.S. Treasury futures contracts. It also buys a put option on the 10-year U.S. Treasury futures contract. This means if rates rise on the 10-year note, the ETF gets price appreciation. But if rates fall, the EFT is only out the price of the put.
Compared with bond index ETFs, which typically charge expense ratios of less than 10 basis points, RISE, which is an active ETF, charges an expense ratio of 50 basis points. With other expenses factored in, the true cost can rise as high at 1.5%, although the fund is targeting a cost around 85 basis points.
“When you rebalance every month and short new Treasury futures to get target duration, you might get a tax hit at the end of the year,” said Thomas Boccellari, an analyst at Morningstar. “The benefit of the active management is, you pay the manager to control the duration for you and to get it right. But you need to understand that you are giving up a lot of yield to get this product and you need to be sure that is what you want to do.”
Two negative duration ETFs tracked by ETF.com are WisdomTree Barclays U.S. Aggregate Bond Negative Duration Fund (AGND) and WisdomTree BofA Merrill Lynch High Yield Bond Negative Duration Fund (HYND) has $32 million in assets, average daily volume of about 11,000 shares, an expense ratio of 0.28% and is up 0.44% year to date. HYND has $6.5 million in assets, average daily volume of about 9,000 shares, a 0.36% expense ratio and is up 2% this year.
Originally published in Investor’s Business Daily.