ETFs Aren’t Plug-N-Play Products

How Advisors Generate Income For Clients

Jeff Schlegel | Financial Advisor Magazine | March 2020

COVER STORY:

We are strong believers in not being all things to all people. Differentiation is highly important in our industry, and we are constantly exploring ways to refine our services to fit our average client’s demographic, typically comprised of income-focused retirees in their 60s. There’s growing concern among this cohort that traditional fixed-income investments will not be able to keep up with their distribution needs in this era of low interest rates. This environment has led some clients to hunt for more complex and “creative” alternatives without assessing how much added risk these changes may bring to the overall portfolio.

On top of that, a shortcoming of bond mutual funds and indexes is that they live on in perpetuity without a true maturity date. They cannot quote an annualized rate of yield-to-maturity because they simply do not mature. That led to the creation of one of the most underappreciated innovations of the exchange-traded fund space: target maturity date bond ETFs.

Taking into account your client’s asset base should be one of the first steps in deciding which investment products to use. Clients might enjoy the excitement of owning individual positions, but with bond portfolios this can lead to inefficiencies if the account isn’t large enough to justify buying a sizable number of small holdings and, for the advisor, it doesn’t justify conducting the ongoing research required of each holding. In addition, the $0 commission movement has not yet been rolled out for bond commission trading. Target maturity date bond ETFs hold a diversified basket of bonds creating a more easily managed laddering strategy conducive to a model portfolio approach.

All underlying bonds within target maturity date bond ETFs mature in the year stated and then distribute a final distribution of the net asset value of the funds’ assets to the investor. This allows ETF providers to quote a weighted average yield to maturity of the underlying positions. This not only helps the client better understand the investment, but also gives the advisor a baseline to make future decisions from.

As with most laddering strategies, a chief benefit to clients is always having a part of their bond portfolio maturing in a relatively short time frame to help fund current income needs and unexpected expenses. This added level of control over duration allows an advisor to choose the specific rungs to the ladder, customized to their client’s specific distribution needs and/or market expectations. For instance, high-yield bonds carry a high correlation with the stock market, with longer duration high-yield bonds having the most relative volatility. If stock market volatility returns in 2020, a holding in high-yield bonds that mature relatively soon (say, in 2021) may have less downside risk versus their longer-duration counterparts. This could possibly create a trading opportunity in a market downturn to sell the shorter duration issues to purchase longer duration high-yield bonds which, in that environment, may be trading at wider discounts to par.

To recap: The diversification to match your client’s investable assets, the ability to communicate a yield to maturity, and enhanced control to target specific points on the yield curve make target maturity date bond ETFs our income producing investment to watch in 2020.

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