Managing Interest Rate Risk with ETFs

Fixed income ETFs are increasingly being marketed as risk-management tools but duration management strategies are probably best suited to institutional investors

Morningstar Europe Editor 14 September, 2010 | 2:24PM
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One of the most commonly highlighted advantages of using exchange-traded funds as an investment vehicle is their flexibility, which allows for an effective management of risk in all possible expressions. Amongst the ETF universe, fixed income ETFs are increasingly being marketed as risk-management tools, and for good reason. Even at their most basic expression, namely as a component of a balanced asset allocation in combination with equity holdings, fixed income ETFs are essentially seen as a means to minimise investment risk. For some investors, their risk-management needs would be fairly well catered for by buying and holding a mainstream fixed income ETF, let’s say one tracking an index covering the entire Eurozone (or solely German for the most risk-averse) government bond market. However, other investors may need to optimise the basic use of their fixed income holdings within an overall investment portfolio. ETFs can be used as a low-cost vehicle to achieve that goal.

In this article we will throw some light on one of their most popular uses, namely as a tool to manage exposure to interest rate risk. The wide choice of maturity-targeted fixed income ETFs and their tradability in real time, affords investors the possibility to quickly put into practice portfolio rebalancing strategies aimed at altering the average duration of overall fixed income holdings. This is greatly facilitated by the ETF’s narrow investment goal of replicating the performance of an index. When it comes to fixed income market indices, the choice goes from those covering the whole maturity spectrum to those measuring the performance of a specific segment. And wherever there is an index, we are likely to find an ETF tracking it. The transparency of an ETF’s underlying portfolio allows for fairly accurate and continuous measuring of duration; which is key to optimise the management of interest risk exposure. This--not to mention real-time tradability--is a crucial benefit that may be lacking in the case of actively managed fixed income funds and which, in our view, could make ETFs a better vehicle to manage duration within an existing fixed income portfolio.

Understanding Duration
The value of fixed income holdings is strongly exposed to changes in interest rates. Rising interest rates drive prices lower, while falling rates drive prices higher. Duration is the most commonly used measure of sensitivity of fixed income assets to changes in interest rates. It is expressed in number of years. The bigger the number, the greater the sensitivity to interest rate moves. From that it follows modified duration, expressed in percentage terms, which measures the approximate change in a fixed income security’s value in response to a 100 basis points (i.e. 1.00%) change in interest rates. The basic duration measures for fixed income ETFs are generally shared by their providers as key product information.

In a nutshell, if you expect interest rates to go up, you would be better off holding fixed income assets with short durations as their price would fall proportionally less than the price of long duration assets. Conversely, if you expect interest rates to come down, you would want to increase duration in order to maximise the potential for capital appreciation. To engage in duration management strategies calls for close monitoring of economic developments and a good understanding of how they ultimately drive monetary policy decisions, not just in terms of direction (e.g. are rates going to go up or down?) but also timing is crucial. This strategy is probably best suited to institutional investors with a need to actively manage investment portfolios, even if through passive index-tracking vehicles like ETFs.

ETF Providers Meet Demand For Duration Management
ETF providers have responded to investors’ needs to manage duration by offering maturity-segmented fixed income ETFs. Most providers now offer a wide array of fixed income ETFs tracking government bond indices measuring the performance of delimited segments of the government bond yield curve. For example, investors wanting to shorten the duration of a fixed income portfolio could easily do so by switching from an ETF covering the whole maturity spectrum to one providing exposure to the very front-end of the government bond curve, like the iShares Barclays Capital Euro Government Bond 1-3y ETF, the Lyxor EuroMTS 1-3y or the db-x trackers iBoxx Euro Sovereign 1-3y TR. Conversely, investors aiming at lengthening duration can switch to ETFs providing exposure to the long-end of the maturity spectrum like the iShares Barclays Capital Euro Government Bonds 15-30y, the Lyxor EuroMTS +15y or the db-x trackers iBoxx Euro Sovereign +25y TR.

These are the two most straightforward examples of how to manage duration and we have only cited three of the main European ETF providers. But the choice is neither restricted to these providers nor to the mentioned maturity segments. Indeed, there are plenty of maturity-segmented ETFs from many other providers and also allowing for the possibility of micro-managing duration by providing exposure to intermediate maturities (e.g. 3-5y; 5-7y; 7-10y). The choice is wide; but, as mentioned, this really is perhaps best suited to those with an active disposition to investment portfolio management. More so, we will never tire of stressing the importance of carefully reading prospectuses. The ETFs we have mentioned may all provide exposure to similar maturity segments, but they do not track the same index. And as any ETF-savvy investor should know, fund performance is largely a function of the performance of the constituents of the underlying index.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Morningstar Europe Editor  .