US fund companies are rolling out new exchange-traded funds aimed at customers looking to get ahead of an expected 2015 Federal Reserve rate hike that could sour bond portfolios. The strategies they expect to employ, though, are complex and likely to be opaque to average investors. The new ETFs rely heavily on derivatives and alternative investments, such as shorting Treasury futures or trading swaps based on mortgage-backed securities, which carry fresh risks of their own, analysts said.
Deutsche Bank AG, BlackRock Inc and AdvisorShares are among firms expecting to introduce new funds over the next few months; last week ETF Managers Capital LLC and Sit Investment Associates launched the Sit Rising Rate ETF.
"Investors really want to be ahead when rates rise," said Dodd Kittsley, head of ETF strategy at Deutsche Asset and Wealth management, which has four interest rate hedged funds in filing with the US Securities and Exchange Commission. "We designed these products with the idea of providing a solution when the timing is right."
This month ten of 19 primary dealers, or the banks that deal directly with the Fed, said they expect a rate rise by June, fewer than the 13 of 20 who predicted an increase in a January Reuters poll. The median expectation for where the federal funds rate will end the year was 0.75 percent. The Fed last raised rates in 2006 and has held its target policy rate near zero since the financial crisis in late 2008.
Income investors wanting to prepare for rising rates could simply hold their money in money market funds or short-term bond funds; those can be had at low cost and are relatively impervious to rising rates. But their lower yields aren't as enticing to income investors.
The new funds promise much higher yields in the face of rising rates. A 1 percent rise in long-term rates could result in a 10 percent rise in a leveraged and hedged fund, for example. To do that, they typically invest in long-term bonds and simultaneously hedge against rate hikes by shorting Treasury futures.
But investors are "giving up a lot in terms of cost of hedging by shorting the Treasury and giving up yield there," said Thomas Boccellari, a fixed-income investment analyst at Morningstar. "It depends on how much interest rates really rise before these things start making sense."
If the Fed doesn't raise rates this year, investors in the new ETFs will get punished, which was the case last year when a widely predicted rate hike never came to pass.
In 2014, as rates stayed low, the WisdomTree Barclays US Aggregate Bond Negative Duration ETF lost 8.1 percent and the ProShares High Yield—Interest Rate Hedged ETF lost 2.5 percent, while the plain vanilla iShares Core US Aggregate Bond ETF returned 6 percent last year, according to Morningstar data.
LEVERAGING RETURNS - AND FEES
The Sit Rising Rate ETF, which began trading last Thursday and has about USD 5 million in assets, uses futures contracts and options on futures on two-, five- and 10-year US Treasuries to target a negative 10-year portfolio duration.
Duration, which measures a fund's sensitivity to interest rates, means that if interest rates rise one percent, investors in the ETF should make 10 percent.
The fund is not designed for market timers trying to get in before rates rise, but instead as a way for buy-and-hold investors to buffer their bond portfolios from rising rates, said Bryce Doty, senior portfolio manager with Sit Investment Associates.
For example, if an investor allocates 10 to 20 percent of the bond portion of their portfolios to the ETF, it could cut interest rate exposure by one-half, he said. "Some clients think about it as a form of collision insurance," Doty said. "You don't know when you are going to have an accident, but you want it before you do."
Similarly, the AdvisorShares Treesdale Rising Rates ETF, which is still in filing, aims to protect investors from rising rates by investing in agency interest-only mortgaged backed securities, swaps and other mortgage-related derivatives.
The fund's goal is to provide 10 to 15 year negative duration, meaning if rates go up one percent, the fund aims to make 10 to 15 percent.
The four Deutsche ETFs in filing, which include funds focusing on emerging markets, high yield and investment grade bonds, also use Treasury futures to hedge interest rates, as does a new BlackRock fund, the iShares Fixed Income Balanced Risk ETF, which is set to launch Thursday. [ID:nL1N0VU15N]
"They are all chasing the same dream which is using the derivatives market to create these inverse strategies," said Dave Nadig, chief investment officer of ETF.com. "But like most inverse strategies, they are fairly risky."
COSTS
Many of these ETFs designed to protect investors from rising rates also don't come cheap.
The Sit Rising Rate ETF, for example, has an annual cost of about 1.5 percent of assets invested, 15 times as much as the Vanguard Short-Term Bond ETF, which has an expense ratio of 0.1 percent. The AdvisorShares Treesdale Rising Rates ETF also has a hefty price tag, at 1.25 percent of assets.
Those costs, along with the lack of a long track record through different rising rate environments, may make some of these funds a tough sell, analysts say.
The high costs of the ETFs are warranted because the funds go beyond simply buying stocks, said Dennis Rhee, a partner with Treesdale.
"These are mortgage-backed securities and swaps off mortgage-backed securities," Rhee said, in reference to their ETF. "It's not a strategy that anyone can employ."
