This Medalist ETF Offers Exposure to Short-Term Floating-Rate Debt

iShares Floating Rate Bond ETF FLOT has a significant cost advantage over its ultrashort-bond and variable-rate peers. The exchange-traded fund's underlying benchmark allows investors to obtain exposure to the opportunity set in this market segment in a cost-efficient manner. These factors underpin the fund's Morningstar Analyst Rating of Bronze.

FLOT tracks the Bloomberg Barclays U.S. Floating Rate Note <5 Years Index, which offers market-value-weighted exposure to investment-grade, variable-interest-rate bonds with less than five years until maturity. These bonds tie their coupon payments to three-month Libor. So, when rates rise, they offer higher coupon payments and their prices don't fall as much as fixed-rate bonds. In contrast, most funds in the ultrashort-bond Morningstar Category invest in fixed-rate corporate and government bonds with less than three years remaining until maturity. The fund effectively protects against rising rates, but it does take moderate credit risk and loses out when rates fall.

More than half of the portfolio is dedicated to the financials sector, up from less than 25% five years ago. This concentration is a source of risk, mostly driven by large U.S. banks. Since 2010, these firms have issued a record amount of debt to take advantage of low rates and meet the strict postcrisis capital requirements.

BlackRock, which manages this fund, has produced a solid index-tracking record. From its June 2011 inception through May 2019, this fund annually trailed its index by 0.22%, a shade above its 0.20% fee. The fund's corporate holdings have helped it outpace the category average. The fund's since-inception return through May 2019 of 1.31% bested the category mean by 0.23%. Its risk-adjusted return, measured by Sharpe ratio, also came out ahead of the category over the same period.

Fundamental View Floating-rate bonds are debt obligations with variable interest payments. Their coupons typically adjust every three months to reflect changes in Libor. These instruments tend to perform well in a rising-interest-rate environment. In this environment, the fund's coupons are adjusted upward, while the value of fixed-rate bond funds tends to decline. On the other hand, when interest rates fall, the prices of fixed-rate bonds gain and floating-rate bonds' coupons are adjusted downward. Even though both groups have a short duration, they behave differently.

For a low fee, this indexed portfolio replicates the composition of the investment-grade floating-rate bond market and reflects the collective views of market participants about the value of each security. But there are some drawbacks.

Market-value-weighting skews the portfolio toward the largest debt issuers. In the floating-rate investment-grade corporate fixed-income market, there has been record debt issuance by U.S. financial institutions in recent years. This has been driven by low rates and postcrisis regulatory changes.

The portfolio is biased toward the financial-services sector, which accounted for more than half of the portfolio as of late June 2019. U.S. bank issuers make up six out of the fund's 10 largest positions. This concentration makes the fund highly vulnerable to sector-specific risk.

Additionally, the fund is concentrated on the lower end of the investment-grade spectrum, with considerable exposure to bonds rated A and BBB. These securities, mostly banking-sector bonds, take up more than 60% of the portfolio. On average, the fund's peers invest roughly one third of their assets in A or BBB rated bonds. While these bonds are on the lower end of the investment-grade credit-quality spectrum, they have relatively low default risk and offer a higher yield than Treasury securities with comparable terms. The balance of assets is in higher-rated AAA and AA securities.

This fund has efficiently tracked its index since its June 2011 inception. From inception through May 2019, it gained 1.32% annually, while the index returned 1.54%. The fund's five-year annualized return through May 2019 of 1.41% was better than 68% of its peers. This outperformance principally stems from its relatively aggressive credit profile. But the fund is likely to lag its peers during market downturns when credit spreads widen.

Portfolio Construction FLOT earns a Positive Process rating because it accurately represents its target universe and weights its holdings by market value, which mitigates transaction costs. This portfolio tracks the Bloomberg Barclays U.S. Floating Rate Note <5 Years Index. The index reflects the performance of U.S.-dollar-denominated, investment-grade floating-rate notes. Securities in the index have at least one month and less than five years remaining until maturity and at least $300 million in outstanding face value. Their interest payments are based on three-month Libor, with a fixed spread. Components of the index primarily include securities of financials and industrials companies and government-related securities. The fund may invest in non-U.S. corporate, government, and supranational entity bonds from several other countries. The index is updated on the last calendar day of each month.

Fees Although there are lower-cost options in the category, FLOT's 0.20% fee is still competitive against other floating-rate strategies and ranks in the lowest quartile of the ultrashort-bond category, earning a Positive Price Pillar rating.

Alternatives VanEck Vectors Investment Grade Floating Rate ETF FLTR and SPDR Bloomberg Barclays Investment Grade Floating Rate ETF FLRN are FLOT's closest competitors. FLRN tracks the same benchmark as FLOT but sports a marginally lower 0.15% fee. FLTR's bogy captures a wider swath of this market segment, as it does not limit its universe by maturity. The result is an even greater degree of concentration in the financials sector and a skew toward lower-quality issues relative to FLOT and FLRN. At 0.14%, FTLR's fee is the lowest of the bunch.

PIMCO Short-Term PTSHX (expense ratio: 0.45%) is an attractive actively managed alternative. This fund carries a Silver rating, reflecting the promising combination of a skilled manager and team plying a risk-aware, multifaceted approach that makes full use of the firm's capabilities. The resulting five-year annual performance through May 2019 of 1.9% beat more than 96% of its category peers.

Bronze-rated DFA One-Year Fixed-Income DFIHX (expense ratio: 0.17%) invests in U.S.-dollar-denominated highly rated bonds with less than two years until maturity, allowing it to take greater interest-rate risk than many of its peers. It still provides robust downside protection, as it targets higher-credit-quality bonds than most of its peers. This well-crafted process should continue to deliver attractive risk-adjusted performance.

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