RISR Commentary for November 2022
Performance Summary
The FolioBeyond Rising Rates ETF (ticker: RISR) returned -3.76% based on the closing market price (-3.52% based on net asset value or “NAV”) in November. In comparison, the ICET7IN Index (US Treasury 7-Year Bond Inversed Index) returned -3.55%, while the Bloomberg Barclays U.S. Aggregate Bond Index ("AGG") returned 3.68% during the same period. This performance resulted from a powerful rally in interest rates that saw the 10-year treasury yield fall from 4.05% down to 3.61% over the month, a decline of 44 basis points (bps). Thus, our performance is consistent with an empirical duration of -8, which is below our target of -10. This has been a consistent pattern in RISR’s performance this year – the fund tends to perform in line with, or slightly better than, target on the way up and tends to be less sensitive on the way down, i.e., when rates decline. This observed asymmetry is a key benefit of using MBS IOs to achieve RISR’s goal of helping investors manage and reduce risk. It also helps reduce overall volatility.
This was the second significant decline in long-term rates that has occurred this year. In our view this is a direct reflection of the market’s lack of confidence in the Federal Reserve’s inflation-fighting commitment.
Because Federal Reserve members have provided inconsistent public statements regarding the Fed’s commitment to bring inflation down, any economic report that suggests any moderation in price increases is immediately seized upon as an “all-clear” signal. When this has occurred, traders have piled into long-duration trades that produce a temporary decline in market rates. It is a version of the “buy-the-dip” mentality that has become deeply embedded in traders’ psyches over the last 10-15 years.
Several “soft” economic reports came to market in late October and early November. In particular, Personal Consumption Expenditures (PCE) reported on October 28 were somewhat lower than market expectations. This was reinforced by the Institute for Supply Chain Management (ISM) report on November 1. Typically, the latter report would not be especially market-moving. But in the current environment, where investors and traders are probing the Fed for any sign of weakness or vacillation, the report was seized upon as a sign that the Fed would soon “pivot” away from raising rates, or at a minimum slow the pace of increases.
In our view, this is a serious misreading of the economic data. This viewpoint was confirmed by several prominent market observers, including former Treasury Secretary Larry Summers, and a wide range of prominent investment managers including Mohamed el Erian. Of course, there are plenty of public voices who take the other side of this debate, but we believe many of those commentators are “talking their book.” Based on the poor performance of a great many funds so far this year, they appear to have been “long and wrong” on rates for quite some time.
As we mentioned last month, RISR’s board of trustees elected to stabilize the fund’s dividend rate. In November we made the first fixed monthly payment of $0.18 per share. We made the decision to do this in response to investor interest in having a stable, predictable income stream. We will re-evaluate this dividend rate next year, and we may change it, but it is our intention to maintain a stabilized dividend indefinitely.
Outlook
On November 30, Fed Chair Jay Powell gave a highly anticipated speech and Q&A at the Brookings Institution, a Washington D.C. policy think-tank. In that speech, he said several notable things:
Despite the tighter policy and slower growth over the past year, we have not seen clear progress on slowing inflation.
Despite some promising developments, we have a long way to go in restoring price stability.
Ongoing rate increases will be appropriate in order to attain a policy stance that is sufficiently restrictive to move inflation down to 2 percent over time.
History cautions strongly against prematurely loosening policy. We will stay the course until the job is done.
He also said:
It makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down. The time for moderating the pace of rate increases may come as soon as the December meeting.
This last quote was the ONLY thing the market heard.
Indeed, this speech was the catalyst for a renewed rally in rates that saw the 10-year bond yield decline another 25 bps over the subsequent two days. Almost immediately as the speech was being delivered, stocks jumped nearly 4%.
It is clear the market is taking any indication, no matter how slight, of a moderation in rate hikes as a sign to add risk and duration. This reaction function would seem well founded given a superficial reading of the Fed’s behavior over the last 10-12 years, or perhaps even longer. Many market participants believe there is still an operative “Fed put,” an implied assurance not to let financial markets decline too sharply. This belief is widespread despite being repeatedly and explicitly renounced by numerous Fed officials over the last 6-9 months. The market is telling the Fed, “it’s not what you say, it’s what you do, that matters.” Or at least what you have done in the past.
This lack of credibility is a serious impediment to the Fed swiftly achieving its objective of getting inflation to its target of 2%. Sadly, the Fed squandered its credibility through many years of fecklessness and knee-jerk reaction to incipient financial market declines. They have trained the markets not to believe them.
Despite the renowned Sir John Templeton’s warning that these are the four most dangerous words in the English language, we firmly believe “this time it’s different.” The inflation that has emerged globally over the last 18-24 months represents a regime change that requires a fundamental change in central bank policy, not just in the US, but around the developed world. It will also require a change in messaging, which policymakers are still trying to figure out.
There is an old joke that goes as follows: A man buys a donkey from a farmer, who promises the buyer the donkey will do whatever it is told. The man takes the donkey away but returns a few days later, complaining the donkey won’t follow instructions at all. The farmer pulls out a 2x4 and smacks the donkey between the eyes. He tells the buyer, “First, you have to get his attention!”
The graph below plots the Chicago Fed’s Financial Conditions Index. A negative value indicates “loose” financial markets conditions, while a positive value indicates “tight” conditions. Despite all of the Fed actions and market turmoil of the last 12 months, we are only now, just getting back to neutral. If we look back at what it took to eliminate inflation the last time it became as severe as it is today, it is clear that there is much more work to be done.
If the Fed and other central bankers around the world are going to get inflation back down to their targets, they are going to have to get the attention of financial markets. It is clear that, despite rate hikes of 375 basis points in the US, they still don’t have it. Eventually they will get it, but the longer it takes, the harder they will have to hit the donkey.
So, the Fed may decide to slow the pace of their rate hikes to 50 basis points per meeting, down from 75. But, despite that possibility, any discussion of an actual “pivot” to lower rates is wildly off the mark, in our view. We believe the odds are very low for a sustained material decline in inflation or interest rates anytime soon. Many investors agree with that outlook, and we hope RISR can continue to be a valuable product for them to express that viewpoint.
However, we designed RISR to have broad appeal to a range of investors, including those who have a more sanguine view. We noted above the stable, attractive dividend we have been able to produce, which corresponds to an SEC 30-day yield of 8.02% as of November 30. That high rate of current income, combined with RISRs comparatively modest volatility[1] we believe make it attractive for income-oriented investors.
Finally, we believe that RISR’s low correlation to other market sectors makes it a great diversifier to a wide range of investors, including traditional 60/40 or other model allocations, or investors focused more directly on fixed income. Please contact us to explore how RISR might fit into your overall strategy, to help you manage risk, while generating an attractive current yield.
For standardized performance click here. The performance data quoted represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than their original cost and current performance may be lower or higher than the performance quoted. Performance current to the most recent month-end can be obtained by calling 866-497-4963. Short term performance, in particular, is not a good indication of the fund’s future performance, and an investment should not be made based solely on returns. Returns beyond 1 year are annualized.
A fund's NAV is the sum of all its assets less any liabilities, divided by the number of shares outstanding. The market price is the most recent price at which the fund was traded. The fund intends to pay out income, if any, monthly. There is no guarantee these distributions will be made.
Total Expense Ratio is 1.01%.
Portfolio Applications
We believe RISR provides an attractive, thematic strategy that provide strong correlation benefits for both fixed income and equity portfolios. It can be utilized as part of a core holding for diversified portfolios or as an overlay to manage the interest rate risk of fixed income portfolios. Alternatively, RISR can be used as a macro hedge against rising interest rates with less exposure to equity beta and negative correlation to fixed income beta. The underlying bonds are all U.S. agency credit that are guaranteed by FNMA, FHLMC or GNMA. There is no financing leverage or explicit short positions that relies on borrowed securities. Also, timing is on our side as the strategy generates current income if interest rates were to remain within a trading range.
Please contact us to explore how RISR can be utilized as a unique tool to adjust your portfolio allocations in the current inflationary environment.
| Yung Lim | Dean Smith | George Lucaci |
|---|---|---|
| Chief Executive Officer | Chief Strategist and Marketing Officer | Global Head of Distribution |
| Chief Investment Officer | RISR Portfolio Manager | |
| ylim@foliobeyond.com | dsmith@foliobeyond.com | glucaci@foliobeyond.com |
| 917-892-9075 | 914-523-2180 | 908-723-3372 |
This material must be preceded or accompanied by a prospectus. For a copy of the prospectus please click here.
Investments involve risk. Principal loss is possible. Unlike mutual funds, ETFs may trade at a premium or discount to their net asset value. The fund is new and has limited operating history to judge fund risks. The value of MBS IOs is more volatile than other types of mortgage related securities. They are very sensitive not only to declining interest rates, but also to the rate of prepayments. MBS IOs involve the risk that borrowers may default on their mortgage obligations or the guarantees underlying the mortgage-backed securities will default or otherwise fail and that, during periods of falling interest rates, mortgage-backed securities will be called or prepaid, which may result in the Fund having to reinvest proceeds in other investments at a lower interest rate.
The Fund’s derivative investments have risks, including the imperfect correlation between the value of such instruments and the underlying assets or index; the loss of principal, including the potential loss of amounts greater than the initial amount invested in the derivative instrument. The value of the Fund’s investments in fixed income securities (not including MBS IOs) will fluctuate with changes in interest rates. Typically, a rise in interest rates causes a decline in the value of fixed income securities owned indirectly by the Fund. Please see the prospectus for a complete description of principal risks.
Diversification does not eliminate the risk of experiencing investment losses.
Footnotes
[1] RISR 30-day volatility, measured as the annualized standard deviation in daily returns, is 16% as of December 9, 2022. Source: Bloomberg, L.P.
Index Definitions
Bloomberg Barclays US Aggregate Bond Index: A broad-based benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency).
US Treasury 7-10 Yr Bond Inverse Index: ICE U.S. Treasury 7-10 Year Bond 1X Inverse Index is designed to provide the inverse of the daily return of the ICE U.S. Treasury 7-10 Year Bond Index (IDCOT7). ICE U.S. Treasury 7-10 Year Bond Index tracks the performance of US dollar denominated sovereign debt publicly issued by the US government in its domestic market. Qualifying securities of the underlying index must have greater than or equal to seven years and less than 10 years remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and an adjusted amount outstanding of at least $300 million.
Cn:The S&P 500 Index, or Standard & Poor's 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S.
IBOXHY Index: iBoxx USD Liquid High Yield Total Return Index measures the USD denominated, sub investment grade, corporate bond market. The index includes bonds with minimum 1 years to maturity,
minimum amount outstanding of USD 400 mil. Bond type includes fixed-coupon, step-up, bonds with
sinking funds, medium term notes, callable and putable bonds.
Definitions
Alpha: a return achieved above and beyond the return of a benchmark or proxy with a similar risk level.
Annualized Equivalent Yield: represents the annualized yield based on the most recent month of income distribution : (income distribution x 12 months)/price per share.
Basis Points (bps): Is a unit of measure used in quoting yields, changes in yields or differences between yields. One basis point is equal to 0.01%, or one one-hundredth of a percent of yield and 100 basis points equals 1%.
Beta measures: the volatility of a security or portfolio relative to an index. Less than one means lower volatility than the index; more than one means greater volatility.
Coupon: is the annual interest rate paid on a bond, expressed as a percentage of the bond’s face value.
Correlation: a statistic that measures the degree to which two securities move in relation to each other.
Convexity: A measure of how the duration of a bond changes in correlation to an interest rate change. The greater the convexity of a bond the greater the exposure of interest rate risk to the portfolio.
CUSIP: An identifier number that stands for the Committee on Uniform Securities Identification Procedures assigned to stocks and registered bonds in the United States and Canada.
Duration: measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.
GNMA: Government National Mortgage Association
FNMA: Federal National Mortgage Association
FHLMC: Federal Home Loan Mortgage Corporation
Short Investment (Shorting): is a position that has been sold with the expectation that it will decrease in value, the intention being to repurchase it later at a lower price.
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