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Squeezing Alpha Out of Bond ETFs

Squeezing Alpha Out of Bond ETFs

Can you buy outperformance cheaply?

Years ago, battle lines were drawn between the proponents of active and passive management. Skirmishing started in the mutual fund space but now has migrated into the realm of exchange traded products (ETPs). There isn't much money under active management in the ETP space yet, but some big players have jumped into the fray.

Just take a look at bond funds. There's only $1.5 billion managed actively in exchange traded fixed income products, compared with $5.4 trillion on the mutual fund side. PIMCO, a giant in bond fund management, already accounts for 99 percent of bond exchange traded fund (ETF) assets and now aims to further its claim to the space by launching an exchange traded version of its mammoth Total Return Fund (PTTRX).

It's long been argued that there's more alpha to be found in the fixed income market than there is in equities. Exploitable market inefficiencies are supposed to abound in bonds. Moreover, active managers claim their ministrations can minimize the tax effect of gains and harvest offsetting losses.

At first blush, it seems as if PIMCO's been able to live up to such claims. Since 2007, PTTRX's total return has averaged 8.6 percent a year versus the 5.9 percent garnered by its benchmark, the Barclays Capital Intermediate Government/Credit Index. But if you look more closely, you'll note that most of the fund's returns are actually derived from the reinvestment of dividends. On a capital appreciation basis, the behemoth fund actually lags the Barclays index with an average annual return of just 1.3 percent a year. Investors may not care about the source of their portfolio gains, but it's clear that spending bond fund dividends can significantly affect future returns.

With that thought in mind, alpha-seeking advisors owe it to their investors to check on the performance of exchange traded portfolios to see what they've actually delivered. Have they, in fact, beaten the market? And if so, at what cost?

Given the history of exchange traded products, we ought to expect the price of active management to be lower in the ETF format than in mutual funds. After all, there's more overhead in a mutual fund operation. Exchange traded products devolve shareholder relations onto financial intermediaries while mutual funds interface directly with investors. Higher accounting, recordkeeping and investor relations costs are built into mutual fund pricing. Categorically, actively managed bond ETFs operate at one-third the average expense ratio of competing mutual funds.

Active Fixed Income ETF Universe

There are seven products in the active bond ETF universe — the oldest launched in April 2008, the newest one (with a track record) in September 2010.

  1. PIMCO Enhanced Short Maturity Strategy ETF (NYSE Arca: MINT)

    Assets: $1.298 billion

    Annual expense ratio: 0.35%

    Benchmark: Citigroup 3-Month T-Bill Index

    MINT is the category's clear heavyweight, accounting for 88 percent of all active bond ETF assets under management. With 80 percent of the fund's assets invested in instruments maturing in a year or less, MINT seeks to outdo money market funds in the production of current income. MINT invests in private- and public-sector issues rated Baa or higher by Moody's, or equivalently rated by S&P or Fitch.

    Not surprisingly, MINT is the most active portfolio in the category. Some of that turnover is, of course, due to the short duration of its investments, but there's also a goodly amount of portfolio tinkering denoted by the low r2 (r-squared) correlation. In fact, four-fifths of the fund's returns can be attributed to active management, according to the calculus espoused by SUNY finance Professor Ross Miller. Miller claims that the bundling of passive and active management understates a fund's true expense. He's devised a method for allocating fund expenses between active and passive management and determines the cost of active management by comparing, through the r2 correlation, an active fund's expense ratio to that of an index fund tracking the benchmark. Essentially, the Miller methodology carves out the actively managed “portion” of the portfolio to derive an active expense ratio.

    The alpha produced by MINT's management is negligible. Since the fund's November 2009 inception, the beta-adjusted annual outperformance amounts to just 34 basis points (0.34 percent) before dividend reinvestment. Still, the alpha is positive which, as we'll see, puts MINT ahead of most of the other funds in the category.

    Investors pay the equivalent of 38 basis points per annum for MINT's active return. The passive component is delivered at an implied cost of 21 basis points, the average expense ratio of Morningstar's Short Term Bond ETF category. Given its published expense ratio, MINT offers the category's best bargain — at just a 3-basis-point premium — for active management.

    With the constant reinvestment of dividends, the portfolio's average annual gain rises from 0.88 percent to 1.31 percent and the alpha coefficient is goosed up to 0.99 percent.

    Performance Since Inception (through 15 July 2011)
    With Dividend
    Without Dividend
    Average Annual Gain 1.2% 0.56%
    Sharpe Ratio 1.27 0.88
    r2 (r-Squared) 0.03 0.03
    β (Beta) 7.57 7.98
    α (Alpha) 0.01 0.00
    (MINT performance data based on monthly closes; other fund performance data determined by daily closes)
  2. PIMCO Intermediate Municipal Bond Strategy ETF (NYSE Arca: MUNI)

    Assets: $96.6 million

    Annual expense ratio: 0.35%

    Benchmark: Barclays Capital 1-15 Year Municipal Bond Index

    Launched in November 2009, MUNI spreads its investments nationwide, committing assets most heavily to California, New York, Florida and Texas paper. The MUNI portfolio hews to the center of its target range with 45 percent of its holdings set to mature within five to seven years.

    MUNI's benchmark returns more fully explain the portfolio's trajectory, at least when compared to MINT's overall gains. The Barclays Capital 1-15 Year Municipal Bond Index has risen at an average annual pace of 4.78 percent since MUNI's inception but on a risk-adjusted basis, MUNI's after-dividend return still falls short of the benchmark.

    With an active weight of 17.9 percent before dividends, investors pay an 11-basis-point premium over the published expense ratio for MUNI's alpha quest. Passive exposure is borne at 30 basis points.

    Performance Since Inception (through 15 July 2011)
    With Dividend
    Without Dividend
    Average Annual Gain 4.81% 2.63%
    Sharpe Ratio 1.77 1.1
    r2 0.56 0.84
    β 1.12 1.18
    α -0.01 -0.03
  3. PIMCO Short Term Municipal Bond Strategy ETF (NYSE Arca: SMMU)

    Assets: $28.3 million

    Annual expense ratio: 0.35%

    Benchmark: Barclays Capital 1-3 Year Municipal Bond Index

    PIMCO's Short Term Municipal Bond Strategy ETF was introduced in February 2010. Though the average duration of the portfolio is under three years, SMMU can invest in longer-dated paper to maximize coupon yields. At last look, in fact, a fifth of the fund's holdings had maturities of 15 years or more.

    The tactic works well in boosting the fund's yield and getting it out of the alpha weeds. Some 35.3 percent of the fund's returns can be attributed to active management which bears an implied cost of 44 basis points. Index exposure weighs in at 0.26 percent.

    Performance Since Inception (through 15 July 2011)
    With Dividend
    Without Dividend
    Average Annual Gain 1.67% 0.64%
    Sharpe Ratio 0.85 1.1
    r2 0.05 0.52
    β 0.73 0.96
    α 0.00 -0.02
  4. PIMCO Build America Bond Strategy ETF (NYSE Arca: BABZ)

    Assets: $26.7 million

    Annual expense ratio: 0.45%

    Benchmark: Barclays Capital Build America Bond Index

    Launched in September 2010, BABZ is the new kid on the block. The fund invests primarily in taxable municipal debt securities issued under the Build America Bond program which was legislated into existence by 2009's American Recovery and Reinvestment Act. The act provides for the sale of paper on which the issuer receives federal support for coupon payments.

    BABZ's largest exposure is to California issuers while two-thirds of the portfolio's holdings mature in 15 years or more. These two factors may explain the headwind into which the fund seems to be aimed. Even with dividends reinvested — more than a third of the portfolio's issues carry coupons between 6 and 7 percent, mind you — the fund lags its benchmark.

    At 11.9 percent, BABZ's active weight is the lowest in the seven-fund universe. That accounts, in turn, for the 1.20 percent active expense ratio, the group's highest. The low active weight and high r2 correlation indicate that the fund is the closest thing to an index-hugger one can find among actively managed bond ETFs. The high premium paid by investors for what little active management is actually done, unfortunately, doesn't buy superior performance. Passive exposure can be obtained at 23 basis points.

    Performance Since Inception (through 15 July 2011)
    With Dividend
    Without Dividend
    Average Annual Gain 4.77% 0.99%
    Sharpe Ratio 0.50 0.11
    r2 0.62 0.92
    β 0.88 0.92
    α -0.03 -0.07
  5. PowerShares Active Low Duration Fund (NYSE Arca: PLK)

    Assets: $8.9 million

    Annual expense ratio: 0.29%

    Benchmark: Barclays Capital 1-3 Year U.S. Treasury Index

    The PowerShares Active Low Duration Fund, introduced in April 2008, is the elder statesman of active bond ETFs, and aptly named. Portfolio managers aim the fund at a target duration of zero to three years, consistent with the fund's benchmark. The bogey's influence on portfolio returns is manifested in the fund's r2 correlation of 0.85 and an active weight of just 16.9 percent.

    Two-thirds of the PLK portfolio is funded by U.S. Treasury notes, with another 15 percent committed to agency securities. PLK's corporate debt allocation is 7 percent currently. Cash and other securities make up the balance of the fund's asset mix.

    Against competing passive exposure priced at 15 basis points, investors effectively pay 62 basis points for PLK's active management — a 33-basis-point premium over its published ratio. For that, they get negative alpha. Only after dividends are reinvested does the alpha meter register positive.

    Performance Since Inception (through 15 July 2011)
    With Dividend
    Without Dividend
    Average Annual Gain 2.06% 0.79%
    Sharpe Ratio 0.22 0.26
    r2 0.01 0.85
    β 0.45 0.9
    α 0.01 -0.02
  6. Columbia Core Bond Strategy ETF (NYSE Arca: GMTB)

    Assets: $5.2 million

    Annual expense ratio: 0.35%

    Benchmark: Barclays Capital U.S. Aggregate Bond Index

    The smallest portfolios in the bond ETF universe started life in January 2010, run by Grail Advisors. Grail was bought in 2011 by Ameriprise, a financial firm originally owned by American Express, with the extant portfolios, including GMTB and GMMB, rebranded as Columbia funds.

    GMTB's mandate — to outperform the widely followed Barclays Capital Aggregate Bond Index — allows the fund to invest widely. As much as a fifth of the portfolio can be invested in high yield or junk bonds but at last look, just 4 percent of GMTB's assets were rated below investment grade.

    Nonetheless, coupons are important — very important — to the management of the GMTB portfolio. No other fund in the universe relies so much on dividends to create alpha. The alpha spread between the before- and after-dividend returns is a whopping 8 percentage points.

    With an active weight of 19 percent and passive exposure priced at 20 basis points, GMTB's portfolio management is expensive at 1.09 percent.

    Performance Since Inception (through 15 July 2011)
    With Dividend
    Without Dividend
    Average Annual Gain 5.91% 2.21%
    Sharpe Ratio 0.92 0.83
    r2 0.01 0.82
    β 0.24 0.96
    α 0.04 -0.04
  7. Columbia Intermediate Municipal Bond ETF (NYSE Arca: GMMB)

    Assets: $5.2 million

    Annual expense ratio: 0.35%

    Benchmark: Barclays Capital 3-15 Year Blend Municipal Bond Index

    The non-taxable analog for GMTB is the Columbia Intermediate Municipal Bond ETF. The fund has a duration target of three to 10 years, though 40 percent of its holdings are skewed at the long end of its asset spectrum.

    Like the owners of its sibling portfolio, GMMB investors rely on dividends to snag alpha. They don't, however, pay up for it. Against passive costs of 30 basis points, the fund's 21.1 percent active weight puts the price of GMMB's management at 44 basis points — one of the lowest mark-ups in the universe.

    Performance Since Inception (through 15 July 2011)
    With Dividend
    Without Dividend
    Average Annual Gain 5.87% 1.94%
    Sharpe Ratio 0.68 0.75
    r2 0.01 0.78
    β 0.97 1.08
    α 0.01 -0.03

Is There Alpha or Not?

The answer to the alpha question is “yes.” But alpha capture requires reinvestment of dividends. The weighted average annual gain, before dividends, for the seven-fund universe is 0.72 percent versus 0.67 percent for the benchmarks. The ETFs' apparent outperformance disappears, however, when you adjust for their higher beta. Plow payouts back into the portfolios and the fund's average annual gain rises to 1.55 percent.

That “yes,” too, should be modified to “yes, but not much.” The weighted average after-dividend alpha shown in the table (following the Morningstar convention) is 1 percent (“0.01”). That value's been rounded up. It's actually just 0.82 percent.

The funds' aggregate alpha, along with the other weighted average portfolio statistics, is heavily skewed by MINT. Nearly $9 of every $10 invested in active bond ETFs has been tucked into the MINT portfolio, which means if MINT sneezes, the whole category would likely catch cold. At least from a statistician's standpoint.

You get a better sense of the universe's diversity by peering through its median values. The wide disparity between the weighted average and the median active weights, r2 correlations and beta coefficients bespeak the gravitational pull of the MINT portfolio.

On a fund-by-fund basis, active bond funds actually aren't that active. The funds' active weights range from 11.9 percent (BABZ) to 81.9 percent (MINT). Take MINT and its monthly data points out of the mix and the range narrows considerably. The busiest fund on a daily basis is SMMU with an active weight of 35.3 percent.

The proximity of the median r2 and beta values to 1.00 (100 percent) also connotes a fair amount of index-hugging.

For investors, the bottom line is this: There is some, but not much, alpha to be scooped up by actively traded bond ETFs. The trouble is, it can all too easily be spent.

Source for all tables: Brad Zigler, Commodity Systems, Inc.

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