ETF Expert Corner

IndexIQ’s Sal Bruno Spotlights Momentum-Based Bond ETFs

September 13th, 2016 by ETF Store Staff

Sal Bruno, Chief Investment Officer at IndexIQ, discusses a smart beta approach to bonds and spotlights the IQ Enhanced Core Bond U.S. ETF (AGGE) & IQ Enhanced Core Plus Bond U.S. ETF (AGGP).



Transcript

You can listen to our interview with Sal Bruno by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: We're actually spotlighting two ETFs this week, the IQ Enhanced Core Bond US ETF ticker AGGE and the IQ Enhanced Core Plus Bond US ETF ticker AGGP. These are the first ETFs introducing a momentum based approach to the bond markets. Joining us via phone from New York to discuss these ETFs is the Chief Investment Officer at IndexIQ Sal Bruno. Sal a pleasure to have you on the program today.

Sal Bruno: Thanks for having me, it's great to be here.

Nate Geraci: Sal, first these two ETFs happen to be the first bond ETFs offered by IndexIQ. What was the impetus for moving into the fixed income space?

Sal Bruno: We're really all about trying to deliver smarter core products for investors, whether it be in the alternative space which is traditionally where we focused and now trying to move into the fixed income space. We've looked at the fixed income environment and it's been a fairly low return environment with interest rates running 25 to 50 basis points on the fed funds rate, and we thought it might be useful for investors to have an alternative way of accessing the core fixed income space in a way they can enhance their returns in the slow yielding environment. We looked around at what was going on in the fixed income space, what was happening in the equity ETFs with the proliferation of smart beta or factor based ETFs and we said well what if we took some of the tried and true principles in the equity smart beta space and apply it to fixed income? We focused on momentum as a bunch of academic research had come out that has been showing that momentum can actually work in terms of allocating across different fixed income sectors. We built upon that research, did our own research and found that you could actually create a product that could be a core fixed income type holding and it has the potential to deliver a little bit higher return than you would get from sort of a straight passive core bond ETF.

Nate Geraci: Sal, before we talk about the first ETF AGGE, we have talked a lot on our program about smart or strategic beta but our focus has always been on the equity side of the equation. I'm curious, how does IndexIQ define smart beta and then why do you believe this might be a better approach to fixed income?

Sal Bruno: Yes, so you know smart beta is not a term that we love, I think it's a little bit overused, but it's basically anything that's non-market capped weighted or trying to deliver something that's a little bit different from the straight market cap weighted benchmarks. We've seen tremendous product development and proliferation and innovation on the equity side and very little on the fixed income side. We think that by using some of the tried and true principles like momentum that's been used not only on equities, but also commodities, currencies, managed futures products use a momentum signal, we decided to look at that on the fixed income side to see if there was a way because there had not been a whole lot of product innovation across the industry in the ETF space on the fixed income side.

Nate Geraci: The first ETF we're going to look at today is the IQ Enhanced Core Bond US ETF, again ticker symbol AGGE. Tell us what this ETF does.

Sal Bruno: This ETF uses the momentum of the different fixed income sectors that make up the aggregate bond universe to try to overweight and underweight different sectors at different points in time. It is a traditional passive ETF, it is a rules based strategy, but is very dynamic in the sense that it will take positions in different of the five sectors that make up the aggregate bond universe. If you look at the aggregate bond universe, it has investment grade corporate, it has mortgage back and then it has treasuries and you can break the treasuries out into three different maturity buckets, one to three years, three to ten and ten plus. You take those and that makes up the five sectors and we actually just use a momentum signal to try to tactically overweight and underweight different of those five sectors in a disciplined risk control fashion against trying to deliver the smarter core type of product.

Nate Geraci: Sal, this ETF actually owns other ETFs, is that correct?

Sal Bruno: It is, so it's an ETF of ETFs and we at IndexIQ have a long history of running ETFs of ETFs. Our flagship product ticker QAI has actually been out since March of 2009 so we have over seven years of experience and that is also an ETF of ETFs. We have over seven years of experience of running an ETF that invests in other ETFs trying to get the benefits of the tax efficiency, as well as the liquidity which is an important point when you're looking at fixed income. Since we do a monthly rebalance, we want to make sure that we can actually implement this strategy, and we found the best way to do that is to actually invest in other ETFs that represent those fixed income sectors as opposed to drilling down into the individual bonds where you could potentially run into more liquidity issues. The ETFs that we're using and investing in are very large, very liquid, very well-known ETFs in the space.

Nate Geraci: Sal for our listeners who may be unfamiliar with a momentum based approach to investing, can you explain high level what the idea is here? Why might momentum investing work, particularly in the bond markets?

Sal Bruno: Momentum is really just trying to capitalize and following the flow of where the performance is on the expectation that that performance will continue for some period of time. Like I had mentioned earlier, it has worked very well across other assets and there's no reason to not think that it would continue to work in the fixed income space, especially when you're not at the individual bond level but more at the sector level. All it really does is it calculates over a short window and a long window the total return for each of those sectors and it's really just trying to overweight the sectors where you have better performance in the short-term relative to the long-term so you're having an improving performance profile for that sector. We're trying to overweight those sectors and where the short-term window is actually moving down relative to the long-term, they were seeing deterioration of performance in that sector and you want to underweight those.

Nate Geraci: Now I know one of the knocks on momentum investing is the potential turnover, and as I think about the bond market in particular it can be very costly to get in and out of positions. How does this ETF attempt to minimize those costs because it seems like those could potentially be a drag on returns.

Sal Bruno: Yes and that's a main reason why we use the ETF to get that exposure because what happens in the ETF market, so the liquidity of the ETF is really derived from the liquidity of all of its underlying instruments, but in some cases you actually get a time when these ETFs actually sort of take on a life of their own and become really great proxies for that sector. You can get that secondary market liquidity, which we see in a number of these ETFs that we're actually investing in, where they're trading the liquidity that they're providing is far in excess of the liquidity of the underlying bond. You can trade in and out of these larger fixed income ETFs pretty much all day without having a tremendous impact or cost, and that is a large driver for the reason for us to actually become an ETF of ETFs and invest in those other fixed income ETFs as opposed to owning the individual bonds.

Nate Geraci: Before we move on here, just for comparison purposes, how do the overall holdings of AGGE compare to the Barclay's US Aggregate Bond Index, which of course we know several popular ETFs track.

Sal Bruno: Right, so again they're owning individual bonds, we're owning ETFs, but if you bring it up to the sector level you'll see that they're about 40% invested in treasuries and about 30% each in investment grade corporate and 30% in mortgaged backs. Our current allocation is 50% investment grade corporate and 50% mortgage backed so we don't have any treasury positions currently and that's really a reflection of where the performance has been over the most recent three to six month window.

Nate Geraci: We're visiting with Sal Bruno, Chief Investment Officer at IndexIQ. Sal the other ETF we're spotlighting today is the IQ Enhanced Core Plus Bond US ETF, ticker symbol AGGP. My understanding is this is very similar to AGGE but it can also include exposure to high yield and emerging market debt, is that really the primary difference?

Sal Bruno: That's exactly the difference. The process that we run is the same for AGGE and AGGP. The main difference is AGGP also includes the potential allocation to high yield as well as emerging markets. For those investors who, and it really depends how investors are treating the high yields and the EMPs. If they have sort of their own separate high yield exposure and they're really just looking for a better core then AGGE might be a better vehicle for them. If they want to sort of roll in all of their bond exposure including high yield and emerging markets into one instrument to try to improve the performance then AGGP might be the better vehicle for them.

Nate Geraci: Sal we've talked quite a bit over the past couple of years about the chase for yield and how investors need to carefully consider all of the risks involved with higher yielding investments. With both of these ETFs we're looking at today, but maybe in particular with AGGP, given the momentum factor do you view these ETFs as a way to enhance yield, manage risk or is it both?

Sal Bruno: It's really more of a total return proposition. Our risk is generally, if you look at standard deviation of returns, our risk is going to be about where you would get with the aggregate bond index with the universe and our yield generally is on average about the same, that will change, can vary, in fact our duration will be pretty close to there's on average through time as well. The main difference is being during periods of time where you have strong momentum and longer term treasuries we're going to shift there and our duration should be a little bit higher because that is where the performance is more likely to come from. From an overall yield and risk and duration we're sort of around where the aggregate is going to be, it really comes from a total return perspective which really means we're driving a little bit more potential on the capital gains exposure part that would drive more the total return.

Nate Geraci: You touched on this a bit earlier, but just to be clear where do you see these two ETFs fitting in the context of a well-diversified investment portfolio?

Sal Bruno: We think these could be very useful as the core fixed income positions, so most investors will have sort of this core holding that they have in their bonds and many of them are using the aggregate bond ETFs or mutual funds or other intermediate term bond mutual funds to get that exposure and we think that these are very possible replacements for some of those positions, again as the smarter core position in the fixed income portion of the portfolio.

Nate Geraci: Again we're visiting with Sal Bruno, Chief Investment Officer at IndexIQ. Sal we have a few minutes left here and just broadly speaking I'd love to get your thoughts on the current fixed income environment right now. We know there are some $12 trillion dollars in negative yielding bonds around the world, rates are still near all-time lows here in the US, but we do have the specter or the fed raising interest rates. Then you add to that the uncertainty over in Europe and Japan and with the US presidential election. We also know some investors are concerned with stock valuations perhaps being too high. How does all of this play into your overall assessment of the bond markets right now?

Sal Bruno: Certainly as you mentioned there are a lot of cross currents going on and you have to be really careful about what you do in any investment, particularly in this environment. The strategies that we've developed I think can actually be pretty good diversifiers. Our research has shown that using momentum in fixed income actually creates a return series not only that can have sort of potentially outperform the aggregate bond universe, but could also be a little bit more diversifying relative to equity. If you look at the correlation of the excess returns for these strategies relative to the equity market they tend to do fairly well when equities have declined, at least in our research. We think that these could be potentially good offerings, especially in light of what you said if we have an interest rate hike we're currently not in the long end of the market, nor are we actually in the short end. We're actually making a little bit more credit calls at the moment, so we really don't have much of a duration back going off that could potentially help the funds going forward, and again they could be diversifying relative to the equity markets which could experience some trouble as corporate earnings have not been spectacular and we've seen sell offs in the equity markets four out of the last five days, most likely due to the fear of the short-term interest rates rising.

Nate Geraci: For longer term investors how concerned do you think they should be regarding a potential rise in interest rates?

Sal Bruno: Having a strategy that can help you maneuver around that can be potentially very helpful and that's sort of what we're offering here. If you have interest rates going up you really don't want to take any duration risks, so having the ability to sort of not always be locked in to a certain duration profile but have the ability to go a little bit shorter on that might be potentially useful in that type of an environment where you are likely to see interest rates higher rather than lower. Although we would argue our house position is that they're likely to be lower for longer than probably more people are expecting.

Nate Geraci: Then lastly here and sort of dovetailing on those comments, just generally speaking how do you think investors should balance risk versus reward as they look at generating income in their portfolios? We know that this has been a very difficult environment, especially for retirees who need that income given where rates have been and so we know people have stretched and reached for yield to find that portfolio income. I'm just curious, again generally speaking how do you think investors should go about balancing that risk reward equation?

Sal Bruno: The key is diversification and clearly if interest rates rise everything that sort of has an interest rate sensitivity is likely to fall to some extent, but trying to get exposure through different vehicles might be potentially helpful, so prefers can have a role there, muni’s could have a role there, traditional investment grade corporate bonds, which if the economy is doing well you may actually get some benefit even if the interest rates are going up you can do a little bit better on the credit spreads that potentially could narrow which they have been doing. There are different ways to try to diversify some of that risk, just spreading it out across different assets. REITs would be another example of an asset class that has a pretty decent yield and may actually do a little bit better. If real estate is doing well and the economy is doing well then you have these corporate buildings being utilized and vacancy rates down, they could actually do well even in a potential rising rate environment. Those types of thoughts are ways of trying to get around just taking a pure interest rate bet.

Nate Geraci: Well Sal with that we'll have to leave it there. We certainly appreciate you joining us today, fantastic perspective on the fixed income markets, very interesting ETFs and we certainly look forward to having you on the program again down the road, thank you.

Sal Bruno: Thank you very much.

Nate Geraci: That was Sal Bruno, Chief Investment Officer at IndexIQ, and you can learn more about both of the ETFs we spotlighted along with the entire IndexIQ ETF lineup by visiting indexiq.com.