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Exchange-traded funds, or ETFs, are portfolio chameleons. They have characteristics that make them well suited to long-term passive investing, just like mutual funds. ETFs also lend themselves to short-term tactical strategies because of their structure.

That can be dicey for small investors. Most investors do best when they refrain from trading frequently, and many of the exotic and esoteric strategies employed by ETFs may be far beyond the needs of individual investors. But small investors can take advantage of the investments’ flexibility and innovation in a couple different ways.

Two types of ETF investments actually help reduce volatility in a portfolio, so they may be employed by investors who want to control against the vagaries of, say, rising interest rates or currency fluctuations.

What it is: Target maturity bond ETF

Target or fixed maturity bond ETFs are like the offspring of an individual bond and an ETF: You get a passel of bonds in one investment that all mature in the same year.

Guggenheim was the first company to offer target maturity corporate bond ETFs, and now BlackRock’s iShares offers them as well. Guggenheim offers high-yield and corporate bond ETFs dated 2014 through 2020 and 2014 through 2022, respectively.

They’re very useful for “targeting specific points in the yield curve in particular,” says CFP professional Peter Lazaroff, CFA, portfolio manager at Acropolis Investment Management in St. Louis.

Why they’re smart investments

Fixed maturity bond ETFs blend the best of both individual bonds and actively managed bond funds, according to Drummond Osborn, president of Osborn Wealth Management in LaPorte, Indiana.

They offer the diversification benefits of a bond mutual fund with the lower interest rate risk associated with an individual bond — provided you hold it to maturity.

Investors get “diversification, greater certainty of yield to maturity and a date to mark on the calendar for the return of proceeds. Because the individual bonds which comprise the ETF all mature within the same calendar year, an investor has a greater sense of the amount of principle being returned,” Osborn says.

In contrast, bond mutual funds have no set maturity and constantly buy and sell issues — whether to replace maturing bonds or to meet investor redemptions or as part of the strategy. The shifting holdings make it more difficult for investors to understand what they own. Because all the bonds in a mutual fund won’t be held until maturity, investors could lose principal if interest rates rise.

Caveats

Though fixed maturity ETFs are less expensive than many bond mutual funds, they do have some costs and expenses.

“Obviously, the ETFs have internal expense ratios and a transactional brokerage cost for their purchase,” says Osborn.

The expense ratios are pretty reasonable compared with those of mutual funds. The average expense ratio for Guggenheim’s BulletShares short-term, intermediate-term and corporate bond ETFs is 0.24 percent, according to Morningstar. The average expense ratio for the BulletShares high-yield bond ETFs is 0.42 percent.

The net expense ratio on the short-term, intermediate, long-term and corporate bond target maturity ETFs from iShares is 0.1 percent. Target maturity municipal bond ETFs cost 0.3 percent.

By comparison, bond funds are a lot more expensive, as shown below.

Average expense ratio of bond mutual funds

Short-term bond 0.85%
Intermediate-term bond 0.89%
Long-term bond 0.79%
Corporate bond 0.86%
Municipal bond* 0.93%

Source: Morningstar

*Includes short-, intermediate-, and long-term municipal bond funds, as well as high-yield funds.

Fixed maturity bond ETFs typically trade at a premium, so investors should be aware that they could overpay for the investments. Osborn recommends using limit orders to try to get a price closer to the net asset value of the fund. A limit order will also help investors avoid the caprices of the market hidden in the spread between the bid and ask.

“You can look on the Morningstar website and see where it has traded and where it is now. I can be a little patient and pick it up at a slightly lower price,” Osborn says.

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Exchange-traded funds, or ETFs, are portfolio chameleons. They have characteristics that make them well suited to long-term passive investing, just like mutual funds. ETFs also lend themselves to short-term tactical strategies because of their structure.

That can be dicey for small investors. Most investors do best when they refrain from trading frequently, and many of the exotic and esoteric strategies employed by ETFs may be far beyond the needs of individual investors. But small investors can take advantage of the investments’ flexibility and innovation in a couple different ways.

Two types of ETF investments actually help reduce volatility in a portfolio, so they may be employed by investors who want to control against the vagaries of, say, rising interest rates or currency fluctuations.

What it is: Currency-hedged ETF

ETFs with a currency-hedging component exist for both stocks and bonds. The currency hedge is designed to mitigate the risk of exchange-rate volatility on investments held in a foreign currency. These ETFs hedge that risk with currency forward contracts or agreements to buy or sell currency at an already agreed upon exchange rate in the future.

Investors could make a bet on currency-hedged equity ETFs if they believe the dollar will appreciate against the foreign currency.

Globe and currency symbols © Jakub Krechowicz/Shutterstock.com

When everything works out just so, equity ETFs with a currency hedge can offer supercharged returns. For example, the Wisdom Tree Japan Hedged Equity Fund went gangbusters in 2013, ending the year up nearly 42 percent, according to Morningstar.

It may be more notable as an exception; such outperformance isn’t always the case, and exchange rates are less predictable than they may seem.

Plus, hedging may reduce diversification benefits in international stocks, according to CFP professional Jonathan Duong, CFA, founder and president of Wealth Engineers in Denver.

“When you hedge the currency out of it, you’re actually making the fund move more similarly to U.S. stocks. The correlation is increasing since you’ve eliminated the currency risk,” he says.

That’s not the case on the bond side, however. “Bond funds should be low volatility. If you allow currency fluctuations, that wouldn’t be the case,” says Lazaroff. Hedging currency risks in bond ETFs offers investors diversification while smoothing out the volatility from exchange-rate shifts. 

Why they’re smart investments

In most portfolios, the bond portion is designed to be a counterbalance against the unpredictable nature of the stock market. Currency fluctuations can throw that out of whack. As much as two-thirds of the volatility of an international bond is the result of currency fluctuations, according to mutual fund giant Vanguard.

“If you have unhedged currency risk in the bond portfolio, it’s that currency risk that’s going to dominate the volatility rather than the benefits you get in the diversification from multiple interest rate curves and varying credit risk,” Duong says.

By mitigating currency swings, investors enjoy the diversification without the exchange-rate noise — going up and going down. Fluctuations due to exchange rates are basically canceled out: Investors won’t realize gains from currency shifts, but their returns won’t suffer either.

Things to think about

Investors should always read the prospectus and understand the types of investments they’re buying. For instance, emerging markets bonds present a different set of risks than those of developed countries. Investing in emerging markets bonds through an ETF without the currency hedge would introduce all sorts of extra volatility into the bond portion of your portfolio — typically the opposite of what you want it to do.

“If you don’t know what you are doing and invest in riskier emerging markets bonds, for example, in an unhedged manner, the real risk is that the foreign bonds are declining and foreign currency is declining and stocks are going down. You end up with a perfect storm, so to speak, where nothing in your portfolio is stable,” says Duong.

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