A Fixed Income ETF Can Moderate Returns Without Sacrificing Liquidity
Traditional investing wisdom recommends a careful mix of stocks, bonds, and cash (sometimes real estate and commodities, too) in order to maximize flexibility while minimizing potential losses. The idea was that stocks provided the flexibility to buy into booming sectors and sell when a particular industry began to wane. Bonds were used to create long-term stability and a guaranteed income with very low risk, and cash provided liquidity to jump on unexpected opportunities when they arose. While cash is still a vital component of any balanced portfolio, a new generation of fixed income ETFs have come along which may end up making traditional bonds obsolete.
For those new to investing, ETF is short for Exchange Traded Fund, and they have turned the investing world on its ear over the last decade. An ETF is a “basket” of securities based on a particular index assembled to achieve a particular investing goal, and the entire basket is subdivided equally into each ETF share. For example, a financial ETF might contain market-cap-weighted shares of Goldman Sachs, Citibank, Bank of America, and dozens of other major companies operating within the financial sector. Shares of that financial ETF can be traded like a stock on any major exchange and the price will rise or fall to reflect the current value of all the combined companies. Literally thousands of ETFs currently exist to cover things as diverse as financials, industrials, transportation, currencies, and even commodities like gold, wheat and oil. Virtually anything you can think to invest in can be bundled into an ETF…anything from the overall health of the housing industry to the price of a jar of honey can become the subject of an Exchange Traded Fund.
This is equally true of bonds, and investing in a fixed income, ETF has many advantages over purchasing bonds directly. A bond ETF will have already purchased an assortment of bonds within the sector it is focusing on and will return the same guaranteed cash flow (payable as quarterly dividends) that you would have received if you had bought the bonds directly. The stability of the bond will also be reflected by the corresponding stability of the share price for the ETF, making it an equally low-risk investment vehicle. The primary advantage to the ETF is that it can be easily and inexpensively sold, like a stock, rather than the expensive and complicated way that bonds are sold, providing much greater flexibility and the ability to cash out quickly if market conditions, or your personal financial situation should dictate. Like all other types of ETFs, there are many to choose. The best-fixed income ETF for your particular financial goals and tolerance for risk should only be chosen after careful research and consultation with your financial advisor.
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Kyle, I like your blog but this post bothered me in a few ways. First, you didn’t call out anything about ETF’s that hasn’t also been true of index mutual funds for decades. So, at least as described, the investment opportunity is not new. Second, bond ETF’s are unlike bonds in one important way: their price risk. With individual bonds you have higher price risk while you hold the bond, but zero price risk at maturity. With ETF’s you have dampened price risk at all times (it’s always being averaged out over time), but ETF’s never mature. Individual bonds in the basket mature, but as a whole the EFT will act as a bond that slowly changes in nature to match the market but never matures. This means that once you put your money in, you have no guaranteed date on which you can recover it all – no point in time at which price risk will return to zero for you. For some investors this doesn’t matter, for others it is a key difference.
Bond ETFs are definitely a useful addition to just about everyone’s portfolio. And as Ethan points out they have some advantages over bond mutual funds that could have been brought out in the post. Ethan also raises the objection that ETFs don’t mature and therefore they don’t have a specific date on which principal is paid. Although I agree it can be important for some investors I believe it is over emphasized in most cases. In any event there are today fixed maturity bond ETFs.
See: http://www.claymore.com/etf/fund/bsch
Before bond investors pile into these they need to understand that bond ETF prices falling means interest rates rising meaning maturities replaced with higher yields and coupon interest rate receipts invested at higher rates. All of this contributes significantly to long term bond market performance.