September 29, 2022

    ETF Insider

    Welcome to this week’s ETF Insider. The Federal Reserve is not letting its foot off of the gas when it comes to hiking rates to control inflation, even if it wreaks havoc on bond prices. But as rates go high (and seem set to keep climbing), advisors and investors appear to be going low (duration). It helps that rising yields allow investors to make money on their safer holdings.

    Where money isn’t going, at least not in significant scale, is into Vanguard’s family of factor-tilting ETFs. The index-fund giant is taking what, for them, is an unprecedented step, closing the smallest of its active factor ETFs for lack of interest. The U.S. Liquidity Factor ETF was supposed to tap the illiquidity premium identified in academic research as the premium investors can earn for tying up cash. But good research doesn’t always make an easy-to-understand investment product.

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    Jackie Noblett, producer of ETF Insider at Financial Advisor IQ.

    Cash-Like ETFs Shine Amid Fed Rate Hikes

    A decade of super-low interest rates and rising equity prices spawned the mantra “cash is trash.” That’s led some advisors to satiate clients’ income needs with all sorts of alternatives, such as high-yield bonds, emerging-market bonds, private assets and dividend-paying stocks.

    But the Federal Reserve’s actions this year have put the kibosh on the lower-for-longer positioning. The federal funds rate last week rose to above 3% and many expect another 1.25% worth of hikes by year end. The sudden result? Investors are falling in love with super-short-duration bond ETFs.

    From Sept. 1 through Sept. 21, investors poured more than $9.3 billion into ETFs categorized by FactSet as ultrashort-term bond strategies. By comparison, investors pulled more than $4 billion from broad maturity bond ETFs during the same period, including $2.2 billion from broad-based high-yield bond funds, FactSet’s database shows.

    There are a few reasons investors have gone to cash-like strategies, analysts told Financial Advisor IQ’s sister publication, Ignites, this week.

    For one, people could be using them as an alternative to money market mutual funds as a place to park cash amid stock and bond market volatility. While some money funds are yielding 2%, the 30-day yield for the $23 billion iShares Short Treasury Bond ETF’s was 2.7% as of Sept. 23. The fund has a duration of about four months and provides investors the intraday liquidity of an ETF.

    But there’s a strategic reason to curtail duration in a broader bond portfolio, depending on where one thinks the Fed is going.

    Vanguard’s head of rates strategy, John Madziyire, explained last week on the firm’s advisor site exactly why short-duration bonds are appealing right now.

    “Right now, the interest rate yield curve is flat, so you get roughly the same yield in short- or long-maturity bonds and bond funds; it makes sense to own short-duration bond funds if you don't want to take a view on the direction of interest rates,” he said.

    The question for whether to stay in short-duration bonds or move back to longer-duration assets depends on largely on whether you think the Fed will push the U.S. economy into recession – thus increasing demand on safe-haven securities like bonds, pushing prices higher – or whether you expect higher rates for longer.

    Gargi Chaudhuri, head of iShares investment strategy Americas, wrote last week that the market pricing in greater rate hikes keeps valuations attractive for short-term bonds, including Treasury inflation-protected securities. "We remain more cautious on longer-dated bonds as we feel that rates can stay at their current levels for some time or even rise.” It may be months before longer-duration bonds seem attractive again, she wrote.

    Whether you believe cash is king or see opportunities to hop into longer-dated issue now, the boom in bond ETFs created during the past decade gives advisors an array of tools not available during the last bear market.

    Video: Methodology Matters in Evaluating ESG

    Click on the image below to hear Nuveen’s ETF chief, Jordan Farris, discuss how the firm’s environmental, social and governance investing expertise has been baked into the methodology behind its index-based products.

    The Lessons in Vanguard’s Factor ETF Flop

    Since launching its first ETFs more than 20 years ago, Vanguard seemed to have the Midas touch when it came to building its lineup. From, exchange-traded share classes of massive index funds like its Total Stock Market Index and Total Bond Market Index, to more recent expansions into international bonds and sustainable strategies, the firm has always been somewhat measured in its new product development.

    The result has been a relatively compact lineup of 82 U.S.-based ETFs representing $1.8 trillion in assets as of Monday, according to FactSet data.

    But Vanguard’s version of factor-tilting strategies have been one of the few ETF areas where investors have not flocked en masse. On Monday, the firm bailed on the smallest one, the $43 million U.S. Liquidity Factor ETF.

    The firm will liquidate the fund in late November.

    The firm says it will keep the other five factor ETFs open. Together, those funds $3.4 billion, but analysts told Ignites that it’s not out of the question that Vanguard might change course on its version of smart beta.

    So why would a firm like Vanguard struggle to capitalize on one of the big ETF investing trends of the 2010s? And what can advisors learn in how they present factor strategies to clients?

    One lesson, analysts say, is that you can build a product on sound research, but you’re on shaky ground it the idea doesn’t resonate with clients. In the case of the U.S. Liquidity Factor ETF, there are plenty of academic papers that have identified and quantified the “illiquidity premium” in stocks and bonds. The premise holds that, over time, investors willing to take long bets on sometimes-hard-to-sell assets, tend to get paid a bit of a buffer.

    But liquidity is not inherently an intuitive factor like size, valuation or stock price volatility. “I never hear investors say, ‘I need some illiquid stocks in my portfolio,’” Jeff DeMaso, head of research of Adviser Investments told Ignites. “You do hear investors say, ‘I need some value or quality or low-volatility in my portfolio.'"

    So, if an advisor can’t clearly explain the case for less-liquid stocks – or even define what illiquidity means in this context – it’s unlikely investors are going to clamor for strategies steeped in them, as they might a thematic or income-producing or sustainable product.

    Investors often buy stories over strategies.

    More broadly – and somewhat specific to Vanguard – investors have come to see smart beta, for better or worse, as a supplement to core index strategies. So much of the money has gone into index-based factor ETFs (Dimensional Fund Advisors’ active factor ETF conversions notwithstanding.)

    Vanguard, for its part, long has held the belief that factors are a version of active, and it built its ETFs accordingly.

    But that approach may have felt off for investors. “Vanguard’s reputation as a leader in providing cheap beta may not have meshed well with these higher active-risk strategies,” Bryan Armour, Morningstar’s passive fund research chief, told Ignites.

    It’s an interesting thought, given that the big three of Vanguard, BlackRock and State Street have largely stayed out of the active ETF product boom sweeping the rest of the market.

    BlackRock has built out active factor funds, and State Street has seen some success in active bond ETFs. But much of their currency with investors and advisors is in the low-cost building-block part of portfolios.