Market Pulse: The problem with fixed-income ETFs
October 25, 2013
The growth in exchange-traded funds (ETFs) has been phenomenal, with assets growing $2.2 trillion in 2013. I've written two books on ETF trading and I've managed some client growth accounts exclusively in ETFs since 2003.
Obviously I'm a fan. That said, when it comes to fixed-income investing it is often best to buy the individual securities rather than ETFs. Here's why.
When you buy an individual bond you know exactly what you'll receive in return. It makes interest payments through its lifetime and then returns par value at maturity.
Its price will fluctuate, but that doesn't matter if you hold the bond to maturity. That isn't the case for most fixed-income ETFs because they never mature.
A 10-year bond ETF may spread the risk to a portfolio of, say, 1000 bonds. While spreading the risk is good, a fund that targets a ten-year maturity has to sell bonds when they fall below the ten-year maturity and replace them with new bonds.
With this constant rotation to new bonds, today's investor doesn't know what his investment will be worth 10 years from now. If rates rise in the meantime, the value of the fund could be far less.
Yes, an investor will receive the income stream but the price swings in the fund can be enormous.
Another downside of the constant buying and selling within a fixed-income ETF portfolio is that it can generate a capital gain. Fixed-income ETFs are one of the few ETF categories that pass along capital gains distributions to investors.
In last week's article I listed two individual fixed-income securities that I like and hold in client portfolios. Another favorite that I've previously written about is HSBC USA Inc. Preferred "D."
This adjustable rate preferred stock is tied to the highest Treasury rate. It currently yields 4.5 percent and its price remained stable when rates rose over the last four months because it is an adjustable-rate security.
Not all fixed-income ETFs are bad, but for my managed accounts I prefer to buy individual securities. This leads to a more predictable outcome and allows me to overweight attractive securities like HSBC USA "D."
Plus it eliminates management fees paid to the ETF. For investors seeking income, this is the better way to go.
David Vomund is an Incline Village-based fee-only money manager. Information is found at http://www.ETFportfolios.net or by calling 775-832-8555. Clients hold the positions mentioned in this article. Past performance does not guarantee future results. Consult your financial adviser before purchasing any security.
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