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Bond ETFs get active

A new type of exchange-traded fund will provide a useful way for bond investors to mitigate risk, says David Stevenson.

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As US interest rates start to rise, bonds as an asset class look unappealing. The US Federal Funds rate (the key short-term rate) is already at 1.75%, and I think it will peak at around 3.5%. Coincidentally, as a rule of thumb, most economists reckon that central banks need to target a rate cut of 3.5 percentage points to stave off a recession which is probably no more than 12 to 24 months away. So at that point, we'd expect US rates to head straight back to near 0%.

But in the meantime, we're likely to see higher interest rates push up the yield on ten-year US government bonds (Treasuries), first past 3% then maybe as high as 3.5%. At those levels, not only might we see a wobble in equities, but we'd also probably see a big sell-off in many types of bonds.

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The rise of active ETFs

This presents investors with a challenge. They probably need to invest some money in fixed-income securities (of which government bonds are one variety). But if prices are falling, they face a risk to capital. So how can you manage that downside exposure? In the UK, most investors have bought into actively managed strategic bond funds, where the manager can switch between different types of bonds, including inflation-linked and floating-rate bonds. With exchange-traded funds (ETFs), the risk is that you have no active manager trying to control downside risk.

This is where active ETFs might play a role. Although it sounds like an oxymoron, these active versions of ETFs are popular in the US a sort of ETF-meets-investment-trust. In the UK, we've already seen big US bond specialist Pimco team up with ETF-issuer Source (now part of fund house Invesco). This has resulted in a range of bond funds, which are in effect the first generation of active bond ETFs while there is a reference index, there is also an active, named, fund manager who manages the portfolio against the benchmark. Until recently, these active ETFs had mainly been sold to institutions who like the idea of buying and selling shares in real time. But I think these funds should also appeal to individual investors.

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Protect against a sell-off

Two funds in particular stand out. The more cautious is the Pimco Sterling Short Maturity fund (LSE: QUID). This invests in short-duration bonds, about two-thirds of which are either investment-grade corporate issues or government bonds. The effective duration is 0.8 years, which means there is a low sensitivity to interest-rate changes (because you don't have to hold the bonds for long until you get your money back).The yield to maturity is 0.72%, although the current running yield is closer to 1.5%. The annual fee is 0.35%.

The other fund is the Pimco Short-Term High Yield Corporate Bond ETF (LSE: STHS). This puts money to work in much riskier corporate bonds and credit. Just over a third of the portfolio is made up of bonds with a duration of between one and three years, and another 51% in three- to five-year bonds. The underlying businesses are 70% BB or B-rated, with a tail of sub-B issuers (below investment grade). Although the yield to maturity is 5.65%, this type of higher-risk bond could be vulnerable in a big bond sell-off. Again, there's an active manager, but the 0.6% fee is cheaper than many corporate-bond unit trusts.

This type of ETF could become attractive in the next few years, especially as there are very few actively managed bond investment trusts. Already other ETF issuers, such as Lyxor, have released bond ETFs which benefit from rising rates these aren't active as such, but use what is, in effect, an active strategy. As bond markets start to wilt in the face of rising rates, expect to see many more active ETFs emerge all looking to manage that downside risk.

Short positions SMT dips into capital

The Scottish Mortgage Investment Trust will dip into its capital reserves in order to maintain its 35-year record of increasing dividends, says Jayna Rana in Investment Week. Over the year to 31 March, the portfolio's net asset value (the value of the underlying portfolio) went up by 25%, while the share price went up by 21.6%, relative to a 2.9% rise for the FTSE All-World index. Despite this performance, the portfolio companies' earnings weren't enough to pay a dividend equivalent to the previous year's 3p per share, even factoring in remaining revenue reserves of 0.47p per share, said the board.

A majority of shareholders, thought to include asset managers BlackRock and Vanguard, has defied the board of gun-maker Sturm Ruger by backing a proposal forcing it to monitor and report on gun violence involving its products, says the Financial Times. BlackRock owns 17.8% of the gun-maker, while Vanguard owns 9.5%.

After a "celestial" performance in 2016, returns have "fallen back to earth" for the Church of England's £8.3bn investment fund, says Jennifer Thompson in the Financial Times. The fund's total return on assets in 2017 was 7.1%, far below the 17.1% it returned the year before. This was also short of its target return of 9.1% and below its 30-year average of 9.4%. Diversification across several asset classes "curbed" the portfolio's performance during a rally in global equity markets, according to the fund's annual report, while the resurgence of sterling against the dollar hampered returns from overseas holdings.

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Activist watch

Xerox will back out of its merger with Japanese multinational Fujifilm, having reached a new agreement with two of its biggest shareholders, activist investors Carl Icahn and Darwin Deason. This is the latest twist in a lengthy tug of war over the future of the iconic American company, says Cara Lombardo in The Wall Street Journal. The new settlement marks a win for Icahn and Deason after "several months of drama" in which they argued that the plan to combine Xerox into an existing joint venture, Fuji Xerox, undervalued the US firm. The new Xerox board, the majority of which is made up of directors backed by the activists, will "immediately begin examining strategic alternatives", such as a sale to a competitor or a private-equity firm.

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