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| The Basics | A powerful, low-cost way to buy bonds
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Exchange-traded funds have worked their way into investors' hearts as a lower-cost, lower-risk way to buy stocks. Four new issues expand their reach into bonds.
By Timothy Middleton
Since first appearing a decade ago, exchange-traded funds have become the market's most potent rival to mutual funds.
One of them, Standard & Poors Depositary Receipt, or SPDR Trust (SPY, news, msgs), has attracted $26.5 billion of assets, or nearly half the assets of the Vanguard 500 Index Fund (VFINX), which goes back more than 25 years. Another, Nasdaq-100 Trust (QQQ, news, msgs), has assets of $17.8 billion, according to the American Stock Exchange, which lists virtually all ETFs. In total, these 120-plus hybrid portfolios have assets of $79.8 billion.
Until recently, ETFs have been strictly equity portfolios. But in mid-2002, Barclays Global Investors launched four bond funds. These new iShares -- Barclays brand of ETFs -- are indexed to three Lehman Brothers government bond benchmarks and a corporate index developed by Goldman Sachs & Co.
They could quickly become one of the most popular investment options on Wall Street. They have the most attractive attributes of conventional mutual funds, such as professional management and thorough diversification. They also have many of the advantages of closed-end funds, which trade like stocks throughout the day and can be margined and sold short. And thats not all.
Exchange-traded funds are superior to both of them, says James Kelly, a financial adviser with Walnut Asset Management in Philadelphia, which uses ETFs in client portfolios extensively. He cites their tax efficiency in particular. They also happen to have much lower costs -- an expense ratio of 0.15%.
We are active users of ETFs, and I would anticipate well be structuring these (bond funds) into our client portfolios, Kelly says.
A look of security
Barclays funds appeared at a propitious moment; by the summer of 2002, in the midst of a vicious bear market, anxious investors yanked nearly $50 billion from equity mutual funds, and much of that money went into bonds.
Meanwhile the collapse of former gilt-edged issuers such as Enron and WorldCom showed how dangerous a portfolio of individual bonds can be. Ten (different) corporate bonds are probably not enough if one turns out to be bad, says Lee Kranefuss, chief executive of Barclays individual investor group.
The ETF issues are pegged to four indices: Lehman 1-3 year Treasury (SHY), Lehman 7-10 year Treasury (IEF), Lehman 20+ year Treasury (TLT) and Goldman Sachs InvesTop Corporate Bond (LQD).
Treasury bonds carry no default risk, so they have the lowest yields in the marketplace. The Treasury portfolios own between 12 and 30 individual bonds, differentiated from each other only in their maturity and yield.
The corporate fund owns 100 names that are the most liquid subset of the GS $ Investment Grade Index. Their average credit quality is A minus. Twelve sectors are represented in varying amounts, from 5-year consumer issues to 30-year financials. The fund has the same maturity characteristics as the intermediate-term Treasury portfolio.
ETFs carry tax benefit
Exchange-traded funds have distinct properties that can make them more attractive than mutual funds. Aside from their stocklike attributes -- marginable, traded throughout the day and shortable -- they have an unusual tax advantage.
ETFs are issued in what are called creation units, which are baskets of all the securities the fund owns, weighted exactly like the index. These multimillion-dollar pools are then broken into small pieces for individual investors. Share prices of the new iShares funds range from $70 to $102 and can be bought through any brokerage just like a stock by name or with the symbols listed above (SHY, ITF, TLT, LQD).
Creation units can also be redeemed, and when they are, shareholders get securities rather than cash. Fund managers can load the redeemed units them with the individual securities that have the lowest cost, and therefore the highest potential capital gains. Institutions dont pay such taxes, so the move is immaterial to them. But retail investors are left with the highest-cost securities, and therefore the lowest potential tax liability.
The low operating costs of these iShares also put them in a class by themselves. The nations premier bond mutual fund, Pimco Total Return A (PTTAX), has an expense ratio of 0.9% -- six times as high as iShares. ACM Income Fund (ACG), one of the most widely held closed-end bond funds, has an expense ratio of 2.31%.
With all of these assets come some liabilities. Like closed-end funds, ETFs carry brokerage commissions, so investors who set aside so much a month, as in a 401(k), will prefer a no-load bond fund. They are not leveraged, as some closed-end funds are, and thus dont yield as much.
The interest-rate sting
And like all bond portfolios they are vulnerable to rising interest rates. If rates were to rise half a percentage point, each of the iShares portfolios would lose some of its capital value. The Treasurys would go down 0.8% in the short portfolio, 3.1% in the intermediate and 6.5% in the long-term fund.
The corporate fund, which has the same average maturity as the intermediate Treasury fund, would likewise lose 3.1% of the value of its principal because of the rate hike. But it might also lose a bit more if the spread between Treasurys and corporates were to widen, as often happens when rates go up. The total shrinkage could amount to more than 4%.
With rates at 40-year lows, they have more room to rise than to fall, and that would be costly to holders of the new iShares.
Most of the gains to be made on the capital side have been made, says Burton Greenwald, a fund consultant whose summer office is on Cape Cod.
For long-term shareholders, this timing issue is not especially troubling. As rates rise, funds are continually buying new issues with higher coupons, so the funds yield is going up. All things being equal, Kranefuss says, that will even itself out.
But its very troubling for short-term investors, such as those speculating on further rate declines, or those holding bonds only until they think the bear market has bottomed, when they plan to redeem them for equities.
Also, actively managed bond funds can sweeten yields by moving opportunistically among various bond categories and maturities. The Goldman Sachs portfolio gained an average of 7.9% in each of the last three years. Fremont Bond (FBDFX), which has the same management as Pimco Total Return but no sales load, spurted 8.9% despite having higher expenses.
So the decision to embrace or ignore the new iShares comes down to passive vs. active management, and the impact of commissions. If you like indexing and are buying enough shares that the commission becomes trivial, iShares are winners. If not, mutual and closed-end bond funds will continue to attract attention, and assets.
At the time of original publication, Tim Middleton owned shares of the Fremont Bond Fund.
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