Fine Tuning Fixed-Income Exposure With Alternative Bond ETFs

Josh Charlson: Hi, I'm Josh Charlson with Morningstar. I'm here with Simeon Hyman, head of investment strategy at ProShares, who is at the Morningstar ETF Conference on a panel talking about alternatives in ETFs.

Thanks for being here, Simeon.

Simeon Hyman: Thanks for having me.

Charlson: Alternatives have been a big growth area in the mutual fund space, and it's natural that there would be interest in ETFs as well. Could you talk a little bit about how you guys are seeing the interest in alternatives and what you're doing about it from a product perspective?

Hyman: Well, most of the brokerages and wirehouses have suggested allocations for their clients of anywhere from 5% to 20%, depending on their risk preferences. So, the theoretical demand is there. And we are starting to see financial advisors working with their clients, looking to fulfill those in myriad ways. And they're becoming more sophisticated as they go along. Sometimes they'll start with a relatively straightforward long-short strategy. But then there is that acknowledgment of "That looks a lot like my equities--maybe I need some more diversifying elements." So, we're seeing the allocations there in the theoretical sense, and now the components there are becoming a little more sophisticated.

Charlson: Post-financial crisis, a lot of people saw alternatives as a way to diversify away from equity exposure. More recently, it seems like the interest-rate environment has been a real concern, and people are looking to diversify away from that traditional Barclays U.S. Aggregate Bond Index exposure. You guys have been coming up with some interesting ways to provide diversification. Could you talk a little bit about what you're doing there?

Hyman: We have a suite of interest-rate-hedged fixed-income products, [ProShares High Yield--Interest Rate Hedged (HYHG)], which is our high-yield interest-rate-hedge product, and [ProShares Investment Grade--Interest Rate Hedged (IGHG)], which is its investment-grade sibling. And we took a very simple, I would say, approach to this issue--which is if you're worried about interest rates going up, you need to bring down the duration in your fixed-income portfolio.

The other alternative, by the way, is you could just swap from bonds to stocks, but you might not want to dial up risk. So, assuming you still want those bonds, you have to bring duration down. You could move to short duration, but you still have some interest-rate risk. Or, you could move all the way to zero duration.

Now, in Treasuries, that would simply be cash, but there is an opportunity on the corporate side to invest in what I would call your regular pile of either investment-grade or high-yield bonds and hedge out the interest-rate risks, such that you have a seamless transition from your existing portfolio construction to one that takes away the interest-rate component.

Charlson: Now, how would these products compare to something like bank loans, where there has been a lot of investor interest in the last year or two?

Hyman: Well, this is kind of a surgical take. In other words, HYHG specifically has in its long portfolio, what I would call, a regular allocation to high-yield bonds. So, it's going to look very much like the high-yield bond products that most clients will have in their portfolios and simply hedges out the interest rates in a very robust manner; three points on the curve, so that you're not exposed to steepening or flattening or twists, and it's rebalanced monthly. So, you know what you're going to get. You're simply going to get your high-yield bonds with the interest-rate risk taken out.

Bank loans have lots of other elements to them. Some of them can help; some of them are heard depending on market environment. They're callable; they have floors on their interest rates, so they're not immediately going to float up. So, there is other stuff going on there, which means that it could be an interesting part of my portfolio; but it's not just a plug-and-play with my existing bond sleeve.

Charlson: And where would you see your products fitting in from an allocation perspective? Do you have a recommended amount in a fixed-income sleeve that they would fit to?

Hyman: What I always tell folks when I'm speaking to them is go back to your asset allocation--go back to your strategic asset allocation--think about where that is, because these are seamless insertions into your fixed-income bucket. So, you have to look at your allocation to see how much fixed income you have. First is strategic side and then to the tactical. One of the other key reasons why we thought it was important to have both the high-yield piece and the investment-grade piece was so that you could divorce the interest-rate decision from the credit decision, so that you can say, "Okay, overall I'm worried about interest rates, so the first thing I'm going to do is bring down duration with a product like this." Then, I can also separately now say, "Do I like credit, or do I not like credit? And do I want to over- or underweight high yield in my fixed-income allocation?"

Charlson: Great. Well, thanks for being here today, Simeon.

Hyman: Thanks very much, Josh.