CLOSING THOUGHTS: TARGET-DURATION ROND FUNDS I

I would like to close this book with a request to readers who might have some influence in the real world. There have been many innovations in the asset management industry over the years, including stock-index funds, industry-specific equity funds, exchange-traded funds, and, recently, target- date retirement funds. From my perspective as a conservative investor, I keep waiting for what seems to me to be the obvious next step – target- duration bond funds.

Fixed-income bond funds typically are identified by issuer type to signal credit risk – government, agency, (investment-grade) corporate, or high yield – and average maturity to signal interest rate risk – ultra-short, shortterm, intermediate-term, or long-term. The bond portfolio often is managed to try to match or exceed the rate of return on some well-known benchmark index of bonds. The fund manager establishes and acts on an interest rate view, in general, regarding likely shifts in the shape and level of the relevant yield curve. I describe this as passive-aggressive.

The development I'd like to see is a family of passively managed bond funds, each targeting a designated average duration. These could be mutual funds or exchange-traded funds. The assets would be high-quality corporate, agency, or Treasury notes and bonds for which interest rate changes are the main drivers of performance. For example, suppose these target- duration bond funds are named D-0, D-l, D-3, D-5, D-8, and so on and are composed only of government securities. The D-0 fund holds overnight positions in very short-term money market instruments. The D-5 fund holds Treasury notes such that the market-value-weighted average modified duration for the portfolio is 5.0, but to be practical might range from day to day between, say, 4.9 and 5.1.

What is the difference between target-duration bond funds and the status quo? Most important, these funds would be passively managed, thereby minimizing operating expenses. The fund managers would not be buying and selling bonds based on a rate view. They would not be putting on flattener or steepener trades or looking for butterfly twists. If derivatives overlays are used, it is merely to keep the fund on its duration target as efficiently as possible. Each target-duration fund also would minimize average convexity.

There are two advantages of target-duration bond funds in my opinion, in addition to lower expenses. First, the investor is presented with a better articulated and more consistent interest rate risk profile than the typical fixed-income bond fund. There simply is more precise information in the names “D-5” and “D-7” than “intermediate-term.” An active investor expecting long-term Treasury yields to fall would want to hold shares in the longest target-duration fund available, for instance, D-12. The investor then could expect that the net asset value of that particular fund will appreciate by about 12% if long-term Treasury yields fall by about 1%.

Second, the investor could use the family of target-duration bond funds to carry out “homemade” immunization. Suppose that an investor has a 7-year time horizon until retirement and would like to invest with minimal interest rate and credit risk. The investor initially would buy shares in the D-7 fund and then smoothly over time transfer the investment to other funds in the family. For example, assuming quarterly rebalancing, three months later one-fourth of the holdings would be transferred from D-7 to the D-6 fund. The average duration is then 6.75 years, matching the remaining time horizon. After another three months, the investment would be divided evenly between D-6 and D-7, and so forth. As the horizon date nears, the funds would end up entirely in D-0. The idea is that the total return over the 7 years tracks what could have been obtained from an initial investment in a 7-year zero-coupon bond, subject to the inevitable model and badly behaving yield curve risks.

Target-duration bond funds need not replace the current array of fixed- income fund offerings. Surely there are investors who are willing to pay the additional expenses to compensate managers who try to enhance returns vis-a-vis the benchmark index by raising and lowering average duration opportunistically. But surely there are others (like me) who would prefer lower expenses and to pursue via target-duration bond funds either a passive investment strategy, such as homemade immunization, or an aggressive strategy based on their own rate view.

 
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