RISR Commentary for September 2024
Click here for a pdf version of this commentary.
Performance Summary
The FolioBeyond Alternative Income and Interest Rate Hedge ETF (ticker: RISR) returned -0.02% based on the closing market price (-0.78% based on net asset value or “NAV”) in September. In comparison, the ICET7IN Index (US Treasury 7-Year Bond Inverse Index) returned –1.32% while the Bloomberg Barclays U.S. Aggregate Bond Index ("AGG") returned 1.34% during the same period.
The Federal Reserve finally reversed course and made the first cut in the Federal Funds rate since March of 2020. The size of the cut, at 0.50% rather than 0.25% which is their typical move, was mildly surprising, because they had not previously suggested such a move, but neither had they ruled it out. Since 1990, when reductions in Fed Funds have occurred, 25 bps moves have outnumbered 50 bps moves about 2:1. At the press conference following the announcement, Fed Chair Powell did not provide an abundance of reasoning about why a larger move was thought necessary. Much of the market speculation turned to recent reported mild softening in labor market conditions.
Source: Bloomberg, LP
As shown in the chart above, there have been 416 months since 1990 when the Fed could have adjusted the Fed Funds rate. In 318 of those months, they chose to do nothing. The largest single rate cut, 150 bps came in March 2020 in response to the covid epidemic. The other notable fact from this chart is that the recent series of rate increases that began in March 2022, was one of the largest and most sustained series of hikes in many years.
What followed the most recent drop of 50 bps was not what the market was expecting, but was exactly what we have been predicting for months—long term rates actually increased. Since the Fed’s move in mid-September the 10-year Treasury rate has increased more than 40bps. The rapid steepening of the yield curve has taken many investors by surprise.
We have positioned RISR for this exact scenario. Over the last 6 months, , the 10-year Treasury peaked at 4.7% and dropped to 3.8% just before the Fed pivoted. Over that same period of time, RISR’s share price reached a high of 35.30 and ended Q3 at 33.97, a drop of less than 3%. Our total return has been more than +6%. The chart below shows a high degree of price stability for RISR despite large declines in longer term interest rates. This is precisely what RISR was designed to do via active management.
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, September be worth more or less than their original cost and current performance September 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 1.13%.
For standardized performance click here.
Outlook and Review
Three Year Anniversary
RISR was launched on October 1, 2021, which means we have just hit our three-year anniversary. This is an important milestone, because many allocators require a three-year track record before they will look at a new ETF. While this means missing out on exciting new products—like RISR—such portfolio guidelines are very widespread in the industry. It is our hope and belief that passing this milestone will open opportunities to bring RISR to the attention of this new wider audience.
We are proud of the performance of this strategy. It has proven its stability through some of the most volatile markets in many years. The table below demonstrates this:
Morningstar 5-star rating
One benefit of passing the three-year mark is that we became eligible to be rated by Morningstar, which reviews and publishes rating on mutual funds and ETFs. We recently were assigned a 5-star rating by the widely followed fund rating firm Morningstar. This is their highest rating and is only granted to the top 10% of funds within an investment category.[1] Since inception, RISR has outperformed the average ETF in our category by more than 55%.
[1] RISR is categorized as a Non-Traditional Bond Fund, by Morningstar.
Outlook
There is an expression that has been attributed to countless figures, from Yogi Berra, to Sam Goldwyn to Niels Bohr. It usually goes something like this: “It is very difficult to make predictions, especially about the future.”
It is very fortunate, then, that investment success does not require making accurate predictions about the future, especially the near-term future. Most predictions about the market over periods of weeks or months are basically guesses and are a very weak basis on which to base an investment strategy.
Instead of trying to time the market, or making predictions about stock prices or interest rates, a much better approach is to look to larger trends and construct portfolios that perform well over a range of potential scenarios. In practice this means adding diversity to an existing central theme, so that overall portfolio volatility is within a tolerable range.
Each investor or investment advisor may have their own view of what constitutes a tolerable range, but it is essential to develop that view. For most fixed income investors, the key driver of return volatility is “duration,” i.e. the sensitivity of the portfolio to changes in market interest rates. The vast majority of fixed-income securities have positive duration, which means they decrease in value when interest rates rise. The greater the duration, the greater the decline in value for a given rise in interest rates. For instance, the 10-year Treasury bond has a duration of roughly 7, which means each 1% change in rates results in a roughly 7% change in value.
RISR, by contrast, has negative duration. As interest rates increase, RISR tends to increase in value. So, by combining traditional fixed-income investment with an allocation to RISR, an investor can greatly reduce the total amount of interest rate sensitivity in the overall portfolio.
The point of this digression is to say that regardless of what happens to markets from here, including RISR in a fixed-income or blended fixed-income/equity portfolio can greatly reduce the portfolio’s sensitivity to change in interest rates, which is one of the primary sources of investment return risk.
In addition, because RISR’s holdings generate significant current income, this risk reduction benefit comes at no cost in terms of overall return. This is very different from other risk reduction measures such as shorting futures, buying options or holding inverse ETFs, all of which tend to have negative “carry.” That is to say, such hedge positions tend to cost money to hold, instead of generating current income.
So, let us now discuss a range of market scenarios over the next year or more in which RISR can help reduce risk:
Scenario 1) Markets stabilize around current levels. Following the recent cycle of rising interest rates that saw the yield curve become deeply inverted (short-term rates above long-term rates), since the Fed stopped its series of rate hikes, and initiated the first cut, markets have begun to revert to a more “normal” pattern of an upward sloping yield curve. As typically happens when the Fed pivots in this manner, medium- and long-term rates have actually increased, as noted above. Currently, the 10-year is reasonably close to its long-term trend of around 4.5%. One possible scenario, then, is that markets generally stabilize more or less where we are now.
In this scenario, mortgage prepayments would be likely to stay comparatively slow. This would enable RISR should continue to earn its carry from underlying mortgage interest, which would enable it to maintain its current dividend. With no trading, NAV would tend to degrade slowly overtime, as organic asset runoff occurs. At the same time, an investor holding a reasonably well-diversified fixed income portfolio could expect moderate accretion in the NAV of the portion of their holdings, which could offset some of move in the RISR position. Of course, trading activity could enhance or detract from these returns depending on timing and skill. All in all, a goldilocks scenario of stable returns, and low to moderate volatility.
Scenario 2) Markets resume an upward trend in rates due to revived fears about inflation or Fed policy. around current levels. If the Federal Reserve is able to achieve the “soft-landing” it has been explicitly aiming for, it would be a rare achievement. Historically, it takes several rounds of policy action to achieve a lasting and durable drop in inflation, especially once it becomes embedded in labor market expectations, as appears to be the case today. Consequently, it is entirely reasonable to envision a scenario in which the current stabilization in prices proves to be temporary, and we see another spike in inflation and interest rates in 2025 or 2026. Indeed, in the post-WWII era, this kind of pattern has been the norm rather than the exception.
In that case, we could expect to see an increase in RISR’s NAV as mortgage prepayment once again slow to levels consistent with hosing turnover rather than refinance activity, as happened in 2022-2024. Over the last few months RISR has been running a duration of around -6. So, if rates increased 100 bps, RISRs NAV ought to rise roughly 6%. As reinvestment of cash flow occurs, we could deploy this into high coupon, new-origination mortgage loans, which could maintain or even enhance the current dividend. Depending on the duration of the balance of an investor’s portfolio, and the size of the RISR allocation, the risk of value loss in this scenario could be partially or largely offset in this case.
Scenario 3) Markets become more volatile due to domestic or geo-political risks. There is a great deal of economic and political risk in global markets today. The US presidential election would appear to be consequential whichever way it goes. The war in the Middle East is expanding rather than contracting, and the prospect of direct confrontation between the US and Iran cannot be ruled out. Oil supplies are particularly vulnerable in this case, and another supply shock could have an enormous impact on prices. The Rusia-Ukraine war likewise seems to be setting up as a prolonged stalemate with tremendous loss of life, and destabilizing impact. Away from political risk, innovation in and rapid adoption of AI appear to have to potential to cause significant disruptions in a wide range of commercial and social activities.
These and other factors could potentially ignite fresh bouts of market volatility. Including RISR in a fixed-income or blended portfolio can have the effect of reducing volatility overall because even in a highly erratic market environment, the low or negative correlation between tradition investments and RISR means that RISR will tend to “zig” as other investments “zag.”
Scenario 4) Some event or circumstance leads to an emergency in which policy makers to sharply reduce interest rates. Ever since the Financial Crisis of 2007-08, policy makers have shown a much greater willingness to deploy extraordinary measures in response to events they perceive as crises. This obviously includes the Fed’s move to reduce interest rates to near zero during Covid. Such emergencies can, of course, occur at any time, and are by nature impossible for most investors to predict. If such an event were to occur, it is hard to say what would happen to investors’ portfolio, whether or not they include an allocation to RISR. A sharp sustained decline in interest rates would normally be expected to cause a drop in RISRS’s NAV, as prepayments accelerated. It is worth noting, however, that during the financial crisis, credit spreads also widened dramatically which slowed prepayments when mortgage originations ground to a halt. Nevertheless, this is the scenario has holds the most potential risk to RISR’s NAV.
We can summarize the foregoing as follows, including our highly subjective rough probabilities over the next 2-3 years:
As we have noted previously, there is a great deal of wishful thinking in the markets at present over how impactful the pivot in Fed rate policy is likely to be. Even if the Fed continues to reduce the overnight Fed Funds rate, the more economically relevant rates will not necessarily follow. We continue to believe it is extremely important for investors to keep a very close eye on risk in their investment portfolios.
Please contact us to explore how RISR might fit into your overall strategy, to help you manage risk while generating an attractive current yield.
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.
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.
Distributed by Foreside Fund Services, LLC.