A Look At the New Bond ETF Families
Interview by John Spence, Associate Editor

After years of development and regulatory hurdles, fixed-income ETFs have finally hit the market. San Francisco-based Barclays Global Investors beat ETF Advisors to the punch with a family of iShares tied to Lehman Brothers bond indexes. New York-based ETF Advisors, headed up by ETF guru Gary Gastineau, earlier this month countered with FITRS (call that "fighters") hitched to Ryan Labs Treasury indexes. We played email catch with index and ETF whiz Brad Zigler to nail down the subtle differences between the two ETF families. Zigler has headed marketing, research, and education for the Pacific Exchange and for Barclays Global Investors. He has also been seen recently penning a column called "Curmudgeon's Corner" for The Journal of Indexes.

Q: The ETF Advisors FITRS are tied to Ryan Labs Treasury indexes, while the iShares are tied to Lehman Brothers indexes. What are the main differences between the Ryan Labs and Lehman bond indexes?

A: Think of the difference between a rifle and a shotgun.

The Ryan index-based ETFs offer narrowly-targeted maturities. They attempt to replicate the returns generated by the most currently auctioned or "on-the-run" 1-, 2-, 5-, and 10-year Treasuries. With the 1-year T-bill's demise, the near-term Ryan index was rejiggered by weighting it two thirds 6-month bills and one third 2-year notes.

The ETF Advisors line-up includes: 1-year FITR (TFT), 2-year FITR (TOU), 5-year FITR (TFI), and 10-year FITR (TTE).

The Ryan index methodology assumes a new auction issue enters an index to replace the previous auction issue on the new issue's auction date. Operationally, that means purchasing the new auction at the offer price and selling the previous auction at the bid price for matched settlement. In reality, a proprietary algorithm determines what mix of securities will be in the actual fund to most closely track the performance of the on-the-run issue. Nonetheless, the benchmark dictates frictional transaction costs at each auction, which can wear on returns.

iShares funds, in contrast, use broader Lehman index maturity buckets:1- to 3-year (SHY), 7- to 10-year (IEF), 20+ year (TLT). Note the absence of a 5-year maturity.

Each Lehman index maturity bucket includes essentially all Treasuries with remaining lives within the target maturity range, with at least $150 million par outstanding, exclusive of special issues like flower bonds, etc.

Additionally, the iShares line-up includes the GS $ InvesTop Corporate (LQD) ETF, based upon 100 liquidity-screened investment grade corporate bonds, equally par weighted, and rebalanced monthly.

Naysayers claim that the Lehman indexes include relatively illiquid "off- the-run" issues that trade with wide spreads, and therefore drive up costs. But the actual fund portfolio will not be a full replication. Representative sampling will be used to recreate the index returns instead.

Investors needing to fill specific niches in a Treasury portfolio, especially those wanting the 5-year note, may find the Ryan index set more to their liking.

Alternatively, those who want to stretch out on the yield curve, and in particular to employ strategies incorporating the long bond (cash or futures), may find the Lehman products more desirable. For those wanting corporate bond exposure, of course, there's only one choice.

Q: Who would trade bond ETFs intraday?

Retail ETF users, from my experience, don't daytrade. What investors like about ETFs is price transparency - that they can trade at a known price on their terms. If one wishes to buy a fund at 11 am, one knows exactly the capital commitment required before pressing the 'send' button.

I think fears about investors falling into daytrading swoons with ETFs are overblown. It's paternalistic to deny the benefits of price and portfolio transparency, lower costs, and tax efficiency to investors just because some pundit doesn't think the product is 'good' for them.

Q: The tax advantages enjoyed by ETFs relate to capital gains, which are less relevant for bond funds. Will this detract from their popularity?

A: Bond portfolios are engines for the generation of interest income. The ETF structure insulates shareholders from certain capital gains consequences; it doesn't provide a tax shelter for interest (or dividend) income. Bond ETF holders will enjoy the same protection against unwanted capital gains as their equity fund brethren. Dividends, however, representing the interest income of the underlying bonds in portfolio, will remain taxable, unless of course the ETF is held in a tax-sheltered account.

And no, I don't think this will detract from bond ETF popularity. After all, tax efficiency is tax efficiency. There's still a potential tax savings to be enjoyed over a conventional bond mutual fund.

Q: What's the next big area of development for ETFs? How about international style funds?

A: Well, there is a hole in the product set where international style funds belong. But that's a very narrow niche not likely to have broad retail appeal. Planners might find such products useful as would institutional users, especially in the absence of comparable futures.

11/15/2002

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