RISR Commentary for October 2024
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Performance Summary
The FolioBeyond Alternative Income and Interest Rate Hedge ETF (ticker: RISR) returned 4.95% based on the closing market price (4.86% based on net asset value or “NAV”) in October. In comparison, the ICET7IN Index (US Treasury 7-Year Bond Inverse Index) returned 3.41% while the Bloomberg Barclays U.S. Aggregate Bond Index ("AGG") returned -2.48% during the same period.
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, October be worth more or less than their original cost and current performance October 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.
For standardized performance click here.
RISR’s performance in October was one of the best since the fund launched in October 2021. This coincided with the fund’s 3-year anniversary and the receipt of a 5-star rating from Morningstar*, which is one of the most widely followed investment analysis firms for institutional investors, wealth managers and individual investors. Morningstar also ranked RISR as the top alternative fixed income ETF out of the 272 funds they track in their Nontraditional Bond Funds category. We are very pleased to be recognized in this way.
*As of 9/30/2024, RISR was rated against the following number of Nontraditional Bond Funds over the following periods: 272 for the 3 year time period. RISR received 5 stars for those periods. Ratings for other share classes may differ. Past performance is no guarantee of future results.
The reason for this recognition is principally due to performance, although other factors are part of the ratings process. Since inception RISR has handily outperformed the broad equity market as represented by the S%P 500 Index (SPX), as well as the broad fixed-income market as represented by the Bloomberg Aggregate Bond Index (LUSTRUU). Indeed, RISR has outperformed a classic 60/40 stock/bond portfolio by more than 30 percentage points over the last three years.
Source: Bloomberg, LP
RISR’s October performance was driven by a very strong rise in interest rates that followed the Federal Reserve’s first rate cut since March of 2020. Mildly surprising was the decision by the Fed, on September 18, to make that a 50 basis point move instead of a less aggressive 25 basis point move, many observers had been expecting. Even now, some 6 weeks since the decision, it is unclear why the Fed chose to send such a signal. In any case, the bond market’s response was to quickly and sharply reverse course. Almost immediately, the 10-year Treasury bond yield reversed the long, grind lower that had prevailed since April. By October month end, 10-year yields had jumped 67 bps from the mid-September low of 3.62%.
10-year US Treasury Yield
Source: Bloomberg LP
This reversal was surprising to many market participants, but should not have been. We have been advising investors for some time of this historical pattern. Most of the time, long-term rates initially rise when the Fed pivots from rate hikes to rate cuts, especially when the yield curve is inverted as it has been since early 2022. Indeed, the inverted yield curve (2-year vs 10-year yields) that had persisted since September 2022 is the longest period of inversion—as well as the deepest—since the late 1970s! It has long been clear to us that once the Fed pivoted, that normalization of an upward sloping yield curve was practically inevitable.
This sequence of events was strangely disregarded by the mainstream financial press and punditry. Even seemingly sophisticated market participants, including banks and prominent real estate investors and real property management firms seemed to think once the Fed began to cut rates, their unhedged, over-levered positions would be bailed out. In fact, for many such investors the situation has worsened. Investors who ignored history and failed to hedge have paid a significant price for their wishful thinking. We believe there is more pain to come.
10-year Treasury Yield Minus 2-year Treasury Yield
Source: Bloomberg LP
As the market dynamics have changed since mid-September, we have seen meaningful inflows to the Fund. We ended September with around $43.9MM in total Fund assets. We ended October with around $50MM, which was helped by a 6% increase in total shares outstanding. It is likely that both the 3-year anniversary plus the new Morningstar rating drew attention to the Fund’s performance. As of this writing we have seen total Fund assets increase by an additional 22% since the end of October, bringing the total to more than $60MM.
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 1.13%.
Market Outlook
Throughout 2024 the Presidential election has loomed large over the markets. The removal of the incumbent President Biden, and his replacement with VP Harris in August, barely 100 days before election day was unprecedented, to say the least. This threw an enormous degree of uncertainty into the markets and the economy. Initially, stocks sold off on and rates rose on the news, but both responses were short lived. The first and ultimately only debate between Harris and Trump occurred barely 30 days later, and the broad consensus was that Trump underperformed his prior debate performances, and that Harris exceeded expectations. However, over the remainder of the abbreviated campaign the debates quickly faded from memory as other remarkable events, including two Trump assassination attempts, dominated the news cycle.
As election day approached, a wide discrepancy emerged between traditional political polls, and the so-called “prediction markets,” where investors could bet on the outcome of the race. The former showed an incredibly tight race, while the latter consistently gave a meaningful edge to Trump. As we now know, the Republican party engineered an historic realignment, with Trump defeating Harris 312-226 in the electoral college victory, as well as capturing a majority of the popular vote. Republicans also captured the Senate from the Democrat majority and seem poised to continue to control the House as well [1].
What then are the implications of this political “red wave” for financial markets and the economy? Trump’s highest relevant priority initiatives would seem to be on: 1) illegal immigration; 2) import tariffs and 3) the ongoing wars in Ukraine and the Middle East.
Immigration
On illegal immigration, it is hard to say with precision how many illegal immigrants [2] of working age are in the US currently. There can be no question, however, that over the last several years, a massive number have entered the US, mostly but not exclusively through the US-Mexican border. A number on the order of 10 million seems widely accepted since President Biden took office, but many of these are children or otherwise not part of the underground work force.
Trump has made it a priority to deport a large number of recent illegal immigrants, although it is impossible to say how many could ultimately be deported, how long it would take or the cost of such an undertaking. There is sure to be resistance from Trump’s political opponents and immigrant rights advocates. The point here is not to engage the political debate on immigration, but to consider the financial and economic implications.
The total US workforce is around 168 million, which included US citizens, as well as legal and illegal immigrants. US citizens constitute by far the majority of this total, but there may be as many as 7-8 million persons of working age who are not legally authorized to reside in or work in the US. So at first glance, the impact on labor markets would seem to be manageable even if the administration were to deport millions.
However, these workers are not equally distributed across all industries. Instead, a preponderance work in agriculture (35% of the total workforce), construction (20%) , textiles (23%) as well as service businesses such as dining (25%) and hospitality (8-10%) [3]. A “successful” effort to deport large numbers of such workers would clearly have implications for wages in those industries. It is also important to note that these are industries where it has been difficult to apply technology to reduce labor costs as an input to production. So, deported workers would have to be replaced with workers who are legal residents. Even if such numbers could be found, it would surely require higher wages to attract willing applicants as such workers have many more employment options. Wage increases have been an important component of overall inflation for the last several years. Thus, a highly aggressive deportation effort would almost surely have inflationary effects.
Tariffs
A tariff is a tax on imports. Tariffs has been used for centuries by countries looking to raise revenue or favor domestic production over the import of foreign goods and services. The functioning principle of a tariff is to increase the final cost of the taxed import to: a) decrease domestic demand for and b) to induce domestic production. The incidence of all taxes (i.e. who ultimately pays the tax), including tariffs, can be highly complex, and economists disagree on some of the particulars. It also depends on the level and scope of the tariffs, which exporters naturally attempt to evade.
There can be no question, however, that tariffs are generally inflationary. Ultimately the tax is borne by someone, and may be differentially allocated across different parts of the supply chain for different goods and services. But if it doesn’t result in a higher price paid by someone, then the tariff will not serve its intended purpose. This is a feature, not a bug.
Trump has suggested he may impose a 10% across the board tariff on most imported goods and services with higher rates for some targeted trade partners. He has suggested Chinese goods may face a tariff as high as 60%. It is important to keep in mind, of course, that US presidents do not have the legal authority to impose across the board tariffs in perpetuity. They have broad authority to impose temporary tariffs for specific reasons, but ultimately Congressional approval is required.
If broad tariffs were seriously contemplated by the new administration, particularly against China as proposed, there would be vigorous pushback among domestic businesses who resell the affected products (e.g. Walmart) and from those who use the imported products as inputs into their own products (e.g. auto manufacturers and pharmaceutical companies). So the political cost of imposing broad based tariffs would be significant. That being said, as with the case of immigration, above, the broader the scope of any new tariffs, the more inflationary the outcome would be.
Military Endeavors
The two major regional conflicts—Ukraine and the Middle East—show little sign of nearing a resolution. The more economically significant war is clearly the Russia-Ukraine conflict. Ukraine was a major global producer of grains, especially wheat. And oil and natural gas supplies from Russia have been significantly reduced since the invasion. Any success the incoming administration might have in bringing this conflict to a close would be most welcome, not least on humanitarian grounds.
We have no expertise in judging whether or how a newly inaugurated President Trump could bring about such an outcome. His campaign pronouncements on promptly ending the war have been bold but have included almost no details. It seems likely that the flow of arms to Ukraine may be curtailed at least somewhat. But if a negotiated settlement to that could be achieved, it ought to lead to the dismantling of the sanctions currently in place against Russian energy exports. It is hard to predict how other suppliers (Iran, Saudi Arabia) might respond to the resumption of Russian energy, but the general direction would presumably be to a further reduction in energy prices, particularly in Europe.
The multi-front conflict in the Middle East is less immediately significant economically. The principal wild card, however, is the increasing intensity of military engagement between Isreal and Iran. If that worrisome trend continues to escalate, any gains from the resumption of Russian energy supplies could be offset by new tensions between the West and Iran, which is the third largest supplier among OPEC member states.
Conclusion – More Volatility
From an economic and financial standpoint, the presidential and congressional elections have done little to reduce future volatility. Despite a dominating ballot box performance, the Republican platform introduces a great deal of macro-economic uncertainty. It may even be possible to say that the more successful the new administration is in implementing its proposed agenda, the more uncertain maters become. Single party rule can sometimes produce extreme outcomes. That is one reason markets often prefer mixed party governments. Each side moderates the other, and highly partisan agendas have to be curtailed to gain broad support.
We may be in for a period where such moderating influences are less impactful. It could be a wild ride. We continue to urge investors to reduce their exposure to volatility generally. Picking tops and bottoms in an environment like this is foolhardy.
Please contact us to explore how RISR might fit into your overall strategy, to help you manage risk while generating an attractive current yield.
[1] As of this writing Republicans have secured 214 of the 218 House seats needed for a majority with several states still counting votes.
[2] We are aware that some object to the use of “illegal immigrant” as a descriptor for those who enter the country without legal authority. The term is widely used, however, in the mainstream press and in official US communications.
[3] Various sources, including Statista, Center for Migration Studies, and New American Economy.
Portfolio Applications
We believe RISR provides an attractive, thematic strategy that provides 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. 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 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 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 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.
The Morningstar Rating™ for funds, or "star rating," is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds and separate accounts) with at least a three-year history without adjustment for sales load. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk- Adjusted Return measure that accounts for variation in a managed product's monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive five stars, the next 22.5% receive four stars, the next 35% receive three stars, the next 22.5% receive two stars, and the bottom 10% receive one star. The Overall Morningstar Rating™ for a managed product is derived from a weighted average of the performance figures associated with its three-, five- and 10-year (if applicable) Morningstar Rating™ metrics. The weights are: 100% three-year rating for 36 - 59 months of total returns, 60% five-year rating/40% three-year rating for 60 - 119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods.
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 Inversed 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.
S&P 500 Index: 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.
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.
Correlation: a statistic that measures the degree to which two securities move in relation to each other.
Coupon: is the annual interest rate paid on a bond, expressed as a percentage of the bond’s face value.
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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