This Cheap Short-Term Bond Fund Can Reduce Portfolio Risk

Bonds can reduce risk in an investment portfolio. A fund such as

Nearly 45% of the portfolio is invested in the financials sector, which is a source of risk. In 2011, this sector represented less than a fourth of the portfolio. The growth of this sector was mostly driven by large U.S. banks. Since 2010, they have issued a record amount of debt to take advantage of low rates and meet strict postcrisis capital requirements. At the end of 2016, the total outstanding debt issued by the financial-services sector stood at $1.6 trillion. Consequently, market-cap-weighting steered the fund toward A and BBB rated financial institution bonds.

The fund's duration is slightly shorter than its category peers. As of November 2018, it measured 1.8 years compared with the category average of 1.9 years. This difference is small. The fund will likely respond to rate movements in a similar way to its peers.

The fund's index-tracking record has improved in recent years. From its inception in December 2009 through November 2018, the portfolio posted annualized returns of 1.8%, lagging its benchmark by 37 basis points. During the past year, the fund's one-year return trailed its index by 0.09%, in line with its expense ratio of 0.07%. This improvement was mostly due to more-favorable sampling as the fund's assets and coverage of the securities in its underlying index increased.

From inception through November 2018, the fund's annualized return of 1.8% kept pace with the category average, lagging by 0.2% per year. But its lower risk profile paid off. This fund's risk-adjusted return, as measured by Sharpe ratio, landed near the top quartile of its category during the same period.

Fundamental View There is a solid case for investing in a broad market-cap-weighted bond index, but the argument isn't as strong as it is for other asset classes. Market-cap-weighting reflects the composition of the fixed-income market, taking advantage of the market's collective view at a low cost. But bond-indexing is generally more difficult than equity-indexing because of the bond market's sheer size. It is also more expensive to trade bonds than stocks. Market-cap-weighting reduces transaction costs by tilting toward the largest issues.

Additionally, issuers' financing activities have a significant impact on the composition of the universe. In the investment-grade corporate-bond market, there has been record debt issuance by U.S. financial institutions in recent years. During 2016 alone, U.S. financial firms issued $299 billion of debt, pushing the total outstanding debt in the sector to $1.6 trillion as of December 2016, according to Fitch. This issuance was largely driven by low rates and postcrisis regulatory changes.

As a result, the portfolio is biased toward the banking sector, which accounted for nearly 45% of the portfolio at the end of September 2018. This single-sector concentration makes the fund highly vulnerable to sector-related risk. Its category peers typically allocate about one fifth of their portfolios to financial institution bonds.

The fund's holdings are concentrated at the lower end of the investment-grade spectrum, with considerable exposure to bonds rated A or BBB. These securities represent more than 80% of the portfolio. This concentration is largely driven by banks and issuers in the telecommunications sector. The average fund in the category invests roughly half of its assets in the A and BBB buckets. Many funds in this group have some exposure to below-investment-grade securities, which this fund avoids.

While the fund's sector and credit-rating distribution differs from the category average, its duration-risk profile is similar to the short-term bond category norm. It had a duration of 1.8 years as of November 2018.

The fund's performance landed near the category average over the past three and five years and since its inception through November 2018. But the fund's risk level was much lower than the category average. Its risk-adjusted return, as measured by its Sharpe ratio, landed in the top third of the category over the same measurement periods. The fund's low fee gives it a sustainable advantage, which should help it continue to produce attractive category-relative performance.

Portfolio Construction The fund employs representative sampling to track the Bloomberg Barclays U.S. 1-3 Year Corporate Bond Index, a broad proxy for the short-term investment-grade bond market. It has lagged its index by a margin greater in magnitude than its expense ratio, principally because of its sampling technique. It earns a Neutral Process Pillar rating. The fund's index includes U.S.-dollar-denominated, investment-grade, fixed-rate, taxable securities with between one and three years until maturity. It holds a range of securities that, in aggregate, approximate the full index in terms of key risk factors, including credit quality and duration, sector composition, and other characteristics. The fund maintains a dollar-weighted average maturity consistent with that of the index. It rebalances on the last business day of each month.

Fees The fund's low fee supports its Positive Price Pillar rating. State Street charges 0.07% for this fund, which is a fraction of the category median fee of 0.52%. The fund's fee ranks in the cheapest decile among its category peers. During the year through November 2018, the fund lagged its benchmark by 9 basis points, an amount near its expense ratio. But this lag was much lower than in the past, and it appears that State Street's measures to reduce tracking differences have been effective.

Alternatives

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