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Using Fixed Income ETFs In Portfolio Construction

Finding income opportunities at low cost in today’s low-yield world has become more of a challenge for investors. In this difficult environment, fixed income ETFs are increasingly the asset class of choice for bond exposure.

Fixed income can perform several roles in a portfolio – income, diversification, returns, liquidity – and deploying it effectively first requires a detailed understanding of an investor’s goals. But whatever those goals are, fixed income ETFs are excellent building blocks for a well-diversified portfolio. There are multiple reasons for this:

Liquidity: If an investor worries about the access to liquidity in times of stress, the impact of selling distressed assets, and the potential situation in which there are no market quotes on certain bonds, fixed income ETFs provide an additional source of liquidity through the secondary market.

Access: Fixed income ETFs can provide one-trade solutions to access different fixed income markets.

Allocation: Whether an investor is looking to add core fixed income exposure to a portfolio, or to overweight/underweight certain asset classes for tactical exposure, fixed income ETFs are efficient tools for allocation across nearly all asset classes.

Duration/credit adjustment: Fixed income ETFs provide an efficient way to adjust duration and credit exposure to suit different investment strategies.

Portfolio completion: Fixed income ETFs are an effective tool to fill exposure gaps in a portfolio without having to engage new investment managers.

Rebalancing: When an investor needs to rebalance their portfolio, ETFs are the quickest and most efficient way to achieve this because they are traded and priced throughout market hours.

A low-cost alternative

Once a decision has been made to use fixed income ETFs, the next challenge is to build a portfolio that matches an investor’s goals. That involves deciding on the right exposure – short-term versus long-term, government versus corporate versus broad aggregate, and so on – then finding an ETF that matches that exposure. In a low-yield environment, finding a low-cost alternative matters more now than ever.

Investors can build a global bond portfolio at low cost with just a few fixed income ETFs. As the illustrations show, Vanguard’s managers are able to deploy their expertise to almost fully replicate the Bloomberg Barclays Global Aggregate Bond Composite Index through flexibility in curve, duration and asset-class trades.

More importantly, investors can use fixed income ETFs to replicate how active fund managers generate alpha, except at much lower cost.

With the stratified sampling approach used by Vanguard, a portfolio can be built under cost, liquidity and size constraints by selecting a subset of benchmark securities that deliver the same risk and return characteristics of the index. Within that framework, portfolio managers can replicate active strategies for different investment scenarios.

Replicated global aggregate bond portfolio

Credits: Enhancing return through carry

Overweighting corporate bonds is a common fixed income strategy for investors who are positive on credits. In the illustrated example, a portfolio manager has replicated an active credit strategy by overweighting short and intermediate-term corporate bonds, which have a higher Sharpe ratio and are less sensitive to spread-widening, thus focusing on the defensive part of the corporate curve.

Rates: Trading on US Treasury curve

Fixed income ETFs can also be used to reflect an investor’s outlook on rates. The US 2-year/10-year curve has been flattening since 2013, and even inverted recently. If an investor expects this trend to reverse and 10-year Treasury yields will rebound, they can use fixed income ETFs to steepen the curve by overweighting short-term Treasuries, underweighting intermediate-term Treasuries and, in the illustrated example, also overweighting long-term Treasuries to keep the overall portfolio duration neutral.

Conversely, if an investor has a different outlook, they can use fixed income ETFs to implement a flattening strategy, capturing the curve by underweighting short-term Treasuries and overweighting intermediate-term Treasuries, enhancing return as the curve continues to flatten.

In a low-yield environment that may persist for a considerable time, choosing a fixed income manager with both proven expertise and a commitment to low costs is a key consideration. Over time, low costs are as important to long-term outperformance as an effective investment strategy.

Three strategies on credit and rates

Originally Posted on September 20, 2019 – Using Fixed Income ETFs In Portfolio Construction

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The information contained in this document does not constitute an offer or solicitation and may not be treated as an offer or solicitation in any jurisdiction. This document is issued by Vanguard Investments Hong Kong Limited (CE No. : AYT820) which is licensed with the Securities and Futures Commission (“SFC”). The contents of this document have not been reviewed by SFC. Investment involves risk.  Past performance is not indicative of future results. Copyright, trademark and other forms of proprietary rights protect the contents of this document. You may not copy, publish and/or distribute any derivative works from the information from this document.

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