US Aggregate Bond ETF – AGG came to market much later than its equity counterpart – SPY
Treasury ETFs such as SHY and TLT offers investors tools to gain exposure to short-term and long-term government debt
Comparison of their performances to SPY’s in different time frames indicates varying return patterns
Overall, equity investment brings higher return but investors need to be very cautious of the risks
In the equity market, the SPDR S&P 500 ETF (SPY) is the pioneer ETF product that tracks a market-cap-weighted index of US large and mid cap stocks selected by the S&P Committee. It’s the largest ETF so far with a staggering amount of AuM – $229.3 billion.
A parallel product in the fixed income arena is AGG, the iShares Core U.S. Aggregate Bond ETF, tracking the Bloomberg Barclays U.S. Aggregate Bond Index. It was launched in September 2003, with $44.5 billion AuM underneath at present. It has a deep liquidity with a spread of 0.01% and a low expense ratio of 0.05%. Note other funds such as BND, SCHZ, and BNDS tracks the same index, with an AuM of $33.8, $3.7, and $1.1 billion respectively. SHY, The iShares 1-3 Year Treasury Bond ETF, also launched as early as in July 2002, has since accumulated $10.9 billion AuM. TLT, iShares20+YearTreasuryBond ETF, tracks a basket of debt issued by the US Treasury with duration of 20 years or more. Its AuM is $7.8 billion now.
Before diving into the construction of the underlying indexes, I checked their expense ration as well as the 60-day average spread for a quick comparison. The following table shows clearly that SPY is the most liquid security while its expense ratio is not slated the lowest. The counterpart AGG offers 4bps lower of the expense ratio, while TLT, and SHY ask three fold – 0.15.
SPDR S&P 500 ETF, well known as SPY, tracks the most popular index, S&P 500. It is designed to reflect the U.S. equity markets, run by an S&P committee to select leading companies from all eligible U.S. common equities (a.k.a. the S&P Total Market Index). Unadjusted company market capitalization of US$ 6.1 billion or more, adequate liquidity and reasonable price are required. a public floating ratio of 50%, significant industry or sector contribution, financial viability are also specified to be elected into S&P 500. (S&P Index Methodology)
The focus of this article is the bond ETFs, so take a look at AGG, which tracks the Bloomberg Barclays US Aggregate Bond Index. The index was created in 1986 with a history backfilled to January 1976, much shorter life span compared to the S&P 500′ rich history, dating back to 1957 (Wikipedia). As to the methodology of index creation, securities with principal and interest denominated in USD are eligible to be included. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and nonagency). They must be rated investment grade, and the minimum amount outstanding is significant; for Treasury, Government-Related and Corporate securities, amount outstanding is raised to USD 300 million. Finally, at least one year until final maturity regardless of optionality is required (US Aggregate Index FactSheet). There are about 6373 holding debt securities in this index as of June 2017, indicating the representativeness of AGG to a broad bond market.
SHY, the iShares 1-3 Year Treasury Bond ETF tracks the ICE U.S. Treasury 1-3 Year Bond Index, switched from the Barclays US Treasury Bond 1-3 Year Term Index on March 31, 2016. Both are the market-weighted index of bonds issued by the US Treasury with 1-3 years to maturity. To create the ICE U.S. Treasury Short Bond Index, the basis of the Eligible Bond universe is those with a minimum effective maturity of at least one year as of the Rebalance Date. Treasury securities issued with calls are removed from the Index for the entire month in which they are called. Each security is required to have a minimum Amount Outstanding of U.S. dollars 300 million. New issuance bought at auction by the Federal Reserve is not included in the Eligible Bond universe. Secondary market purchases by the Federal Reserve that occur in the current month are not reflected in the Index until the following month. Coupon must be Fixed Rate only, excluding zero coupon rates. It contains 75 holdings as of August of 2017. In all, it’s designed to capture short-term Treasury exposure, thus, be less susceptible to interest rate fluctuations than long-dated bond indexes.
TLT, iShares 20+ Year Treasury Bond ETF, tracks ICE U.S. Treasury 20+ Year Bond Index. Contrast to SHY’s underlying index, this index is designed to gain exposure to the US Treasury with maturities of 20 years or more. Hence, it’s highly sensitive to long-term interest-rate movements. What’s worth mentioning is that the fund – TLT- containing 33 holdings, has even higher duration than its benchmark, so the interest impact is larger on the fund level.
With a solid understanding of their underlying indexes, we shall be better at picking the right ETFs for investment under different circumstances. In general, everybody wants to have a higher capital appreciation, less volatility and nice fixed income payment from his/her asset, I’d like to plot the historical performance charts of these 5 ETFs to see how they stack up to each other.
From the 10-year historical price return chart above, you can see BND, AGG, and SHY are quite flatten as expected, but the comparison between TLT and SPY is attention-grabbing. Until around 2016, TLT not only completely out-beats the equity representative fund – SPY but also with a stellar risk profile, note its return is always above the water. Especially during the financial crisis in 2009, when SPY took a nose dive of greater than 60%, TLT spiked 30% more.
Is it true that investing in fixed income yields a better return than in equity market? Without a thorough testing with different time-windows, the conclusion could be misguiding and untrustable. So I plotted a 5-year and a 15-year chart respectively:
In a 5-year time frame, it looks drastically different: SPY beats TLT substantially, thanks to the continuously bullish market.
Extending to a 15-year time frame, the chart looks quite different again. We see that equity investment went through a full cycle from the end of 2002 to 2009, and is now on the upward slope again, climbing to possibly another peak. Measured by the 15-year timeline, it seems investors are better off by inputting money into SPY than into TLT, even being cognizant of the fact that they were entirely wiped out at 2009 crashing point, while TLT holders enjoy a steady price appreciation and coupon income, the overall return is far less than SPY.
The rest of the bond ETFs – AGG, BND and SHY are significantly lack-luster in terms of price performance, with the SHY more flatten-out explainable by its exposure to short-term (1-3 years) bonds. However, we should not dismiss the other returns from coupon and paydown returns associated with investing in such ETFs.
The conclusion I drive is twofold: one, the profitability of equity market is usually much higher than that of bond market; two, the equity market is precarious even when investors are armed with an aggregate and broad ETF such as SPY. For people who want to leverage ETFs for their investment strategy, a close and accurate monitoring of the whole economy is indispensable. We all should grasp what Ray Dalio fervently advocates – to understand how the economic machine works -, to capitalize on the market when it’s booming, and hedge or pull out when it’s declining.