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Friday, March 4, 2011

Finance Friday #3 : Looking at Corporate Bond ETF's ?

Matthew J Patterson advises us to be aware that their portfolio turnover rate of such funds is an  "invisible performance killer" that "drives negative tracking error and eats into investor returns."

How ?
The shockingly high levels of portfolio turnover in corporate bond ETFs largely stems from an arcane rule of index construction that was created by the first-ever bond index, the Lehman Aggregate Bond Index, and subsequently adopted by most of its predecessors, including all of the indices tracked by the corporate bond ETFs in the table above. This rule of index construction, called a minimum maturity rule, excludes bonds from indices when the bonds reach a certain minimum maturity.
Minimum maturity rules make sense for investment banks that deal in bonds and wish to facilitate purchases and sales of bonds by customers who track their indices. They make little sense for investors in corporate bond ETFs. One of the primary benefits of investing in bonds is the return of principal upon maturity. Minimum maturity rules throw this benefit out the window and instead force fund managers to sell every bond (and pay associated transaction costs) when it reaches a certain minimum maturity.
Is there no way around this ?
Glad you asked.
A recently developed fixed income indexing methodology, maturity-targeted bond indexing, addresses the issue of high portfolio turnover in corporate bond ETFs by holding bonds until they mature. Unlike traditional bond indices, maturity-targeted bond indices target a particular year of maturity and do not employ minimum maturity rules. This approach results in indices with very low turnover and bond-like cash flow characteristics, where principal is redeemed and returned to investors at the conclusion of an index’s designated year of maturity.
The first maturity-targeted bond ETFs launched in January 2010 and there are now 17 such ETFs trading on U.S. exchanges. Of these, 11 have published semiannual reports containing partial-year portfolio turnover figures.
 And just what funds are these ?  Check out Patterson's article ''The Biggest Cause of Tracking Error in Corporate Bond ETFs ' at SEEKING ALPHA.