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Investors Hinge ETF Strategy on Fed Tapering Timing

Squeamishness over possible Fed tapering has weighed on ETF markets, but analysts say the key lies in navigating the uncertainty.

After the Federal Reserve Board announced on September 18 that it was going to postpone tapering its quantitative easing program, investors could breathe a bit easier — at least for the time being. “Tapering is inevitable,” says Todd Rosenbluth, director of exchange-traded fund and mutual fund research for S&P Capital IQ. Investors should make use of this newfound time to assess their interest rate risk against several ETFs that offer opportunities with different levels of return versus risk, he says.

“Investors are concerned about the degree to which interest rates will rise and how fast,” says Thomas Urano, a portfolio manager and senior trader for taxable fixed-income and equity strategies at Austin, Texas–based Sage Advisory Services, which has $10 billion in assets under management. The Fed’s decision to delay tapering means that investment managers have to gauge exactly how much investor skittishness has already factored into the market and how much more will weigh in following the eventual wind-down of stimulus spending. But the Fed’s delay also means that fixed-income markets have some time to recoup, he says.

“There also is a budget battle and more data expected to be released on the economy,” says Urano. “That creates a little uncertainty in the markets in general. And risk assets don’t generally do well in times of uncertainty. I definitely want to remain defensive from an interest rate standpoint.”

The uncertainty has been playing out in the market during the past several weeks. Earlier, in August, investors yanked some $6.6 billion from U.S. ETF bond funds, prompted by fears that the Fed was curbing its $85 billion monthly bond-buying program, says Rosenbluth, quoting numbers from BlackRock. In September investors pulled an additional $7.5 billion from taxable bond mutual funds and moved from intermediate- and short-term debt. But Rosenbluth, whose team watched as cash also flowed into shorter-duration bond funds in August, sees other options.

“ETF investors aren’t locked into a mutual fund or worried about supply in the case of individual bonds,” he notes. The plays, aimed at high yield for greater interest rate risk, mostly depend on two factors: how much over the risk-free rate of return an investor wants to go and the news coming from Washington and elsewhere. ETFs are suitably structured to enable sudden moves in strategy, such as shifting from intermediate- to short-duration bonds, should rates jump or the Fed taper.

With regards to intermediate-duration bond ETFs, S&P Capital IQ’s Investment Policy Committee recommends BlackRock’s iShares three-to-seven-year Treasury Bond ETF as a risk-averse choice. It has a short duration of 4.5 years but a low yield of 1.4 percent. The committee is also talking up Guggenheim BulletShares 2016 High Yield Corporate Bond ETF, which holds riskier B-rated, 4.3-year-duration corporate bonds offering a higher yield of 4.9 percent. Rosenbluth has a negative take on Pimco’s Enhanced Short Maturity ETF Fund (MINT), which has an average duration of just 1.2 years and a year-to-date yield of less than 1 percent.

The MINT exchange-traded fund went down less than many other fixed-income ETFs as rates moved higher over the spring and summer. “If rates don’t keep climbing, you’re just getting less for your investment,” Rosenbluth reasons. But at the same time, he mentions market chatter about the Federal Reserve’s taking action before the end of the year — rumors that were confirmed on September 27 by Charles Evans, head of the Chicago Fed.

“If you take that seriously, the MINT makes sense for you,” Rosenbluth says. “If you don’t and the rates stay around where they are for the next six months, taking intermediate risk is appropriate.”

This past March, Van Eck Global launched the Market Vectors Treasury-Hedged High Yield Bond ETF, a low-duration fund that is long a diversified portfolio of high-yield corporate bonds and short an equivalent amount of five-year Treasuries. The fund’s goal is to mitigate the impact of the Treasury yields “but not the credit risk or movement in credit spreads, due to the long portfolio of high-yield corporates,” says Francis Rodilosso, the fund’s portfolio manager.

“High-yield bonds and credit spreads were at historic lows, and there was a lot of low-interest refinancing,” Rodilosso says of the thinking at Van Eck in late 2012, when the firm started developing the fund. “So interest rate risk was greater than credit risk in portfolios,” which pointed to the need for another product that could limit interest rate risk.

Investors looking less for yield than for a way to ride out interest rate uncertainty might want to consider IndexIQ’s multiasset Hedge Multi-Strategy ETF (QAI). Pension funds, investment banks and wire houses are offering the fund, launched on March 25, 2009, on their platforms. QAI holds a mix of equities, commodities, real estate and bonds, says Adam Patti, CEO of the Rye Brook, New York–based fund company.

“It’s about minimizing portfolio volatility,” he says. “We don’t position QAI as a yield play.”

Patti says he expects the fund to deliver a total return of 3 to 6 percentage points higher than risk-free investments if rates stay the same or rise — a projection that has already come to fruition so far. “QAI,” says Patti, “outperformed the aggregate bond market by 5 percent this year.”

Read more about indexing and ETFs.

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