By Matthew J. Patterson :
In an earlier piece published on SeekingAlpha , I discussed how minimum maturity rules drive needless turnover in index-based bond ETFs. Such unnecessary portfolio turnover generates transaction costs that eat into investor returns over time and undermine many of the benefits of passive investment strategies.
Other costs associated with high levels of portfolio turnover are less visible, however, and are often baked into the returns of the underlying indices that many index-based bond ETFs seek to replicate. These invisible costs stem partly from the transparent, rules-based nature of most fixed income indices, which permit sophisticated investors to front run trades of index-based bond ETFs, and partly from the massive size of the most successful index-based bond ETFs, which results in their trades moving the markets for securities in which they transact.
A working paper recently authored by researchers at the University of Washington Tacoma, and co-authored by Accretive Asset Management's Darrin DeCosta, seeks to quantify the invisible costs of index minimum maturity rules by examining the performance of bonds removed from the iShares iBoxx $ Investment Grade Corporate Bond Fund ( LQD ) because of the three-year minimum maturity rule employed by LQD's underlying index. Based on their research findings, the researchers concluded that the relaxation of the underlying index's minimum maturity rule could result in significantly improved risk-adjusted performance for LQD.
Minimum Maturity Rules and the Power of Path Dependence
Minimum maturity rules are rules of index construction employed by many fixed-income indices that call for the deletion of bonds from an index when they reach a certain minimum maturity. The most famous fixed-income index, the Barclays Capital Aggregate Bond Index (previously known as the Lehman Aggregate Bond Index), employs a one-year minimum maturity rule, meaning that bonds otherwise eligible for inclusion in the index are deleted when they reach one year remaining to maturity.
The rationale underlying minimum maturity rules may seem unclear at first glance, particularly in light of the growing popularity of fixed-income indices as the basis of investment products. As the former chief global fixed-income strategist for Lehman Brothers has noted , however, the first bond indices were not designed to serve as the basis of investment products. Rather, they were intended to serve as benchmarks for institutional bond managers to demonstrate the value they add to client portfolios. In this context, minimum maturity rules can be justified, since bonds with less time to maturity are less volatile and therefore offer limited opportunities for bond managers to differentiate their performance from market averages.
Less compelling is the case for employing minimum maturity rules in fixed-income indices intended to serve as the basis of investment products. Since most index-based bond ETFs seek to minimize tracking error relative to their underlying indices, the practical impact of minimum maturity rules in this context is that many index-based bond ETFs never hold a single bond until maturity. As a result, they generate transaction costs that could otherwise be avoided simply by holding bonds until maturity. Moreover, minimum maturity rules often force index-based bond ETFs to sell bonds at inopportune times, when prices of deleted bonds have been depressed because of index front-running by sophisticated investors or negative market movements driven by the selling activity of the index-based bond ETFs themselves.
Despite the costs associated with managing bond portfolios against fixed-income indices that employ minimum maturity rules, most fixed-income indices continue to delete bonds prior to maturity. While minimum maturity rules may serve a defensible purpose in some instances (for example, in bond ETFs that seek to maintain a perpetually high duration by design), in other cases minimum maturity rules appear to survive because, well, that's the way things have always been done in the fixed-income indexing world.
How LQD's Minimum Maturity Rule Effects Individual Bond Prices
To evaluate the impact of LQD's minimum maturity rule at an individual bond level, the researchers compared the performance of LQD index deletes over a sample period (September 2006 to June 2011) to those of matching corporate bonds with similar risk characteristics and comparable average daily trading volumes. Based on this analysis, using valuation data from FINRA's TRACE database, the researchers concluded that the LQD index deletes significantly underperformed the matching bonds in a one-to-two month period around their removal from LQD.
The table below presents the average underperformance of LQD index deletes compared to the matching bonds over various time periods. In the "Holding Period" column, week 0 is the week in which the LQD index delete was removed from LQD's portfolio. For example, a holding period of week -3, week 3 indicates that the relative returns of the LQD index deletes and matching bonds were compared over a period beginning three weeks prior and ending three weeks after the removal of the LQD index delete from LQD's portfolio.
Mean Underperformance of LQD Index Deletes
week -3, week 3
week -3, week 4
week -2, week 3
week -2, week 4
week -1, week 3
week -1, week 4
week 0, week 3
week 0, week 4
week 1, week 3
week 1, week 4
The researchers concluded that the underperformance of the LQD index deletes relative to matching bonds suggests that "removing bonds due to minimum maturity rules can result in significantly negative price impact, that the impact may last for several weeks, and that it is economically significant to [LQD] shareholders."
Quantifying the Impact of LQD's Minimum Maturity Rule on Portfolio Performance
To evaluate the impact of LQD's three-year minimum maturity rule on a portfolio level, the researchers created a hypothetical portfolio by relaxing the minimum maturity rule so that the hypothetical portfolio contained both the LQD portfolio and the bonds that were removed from LQD because of the minimum maturity rule at each monthly rebalancing.
The returns of the actual LQD portfolio were then compared against the returns of the hypothetical portfolio over the 57-month period from October 2006 to June 2011 (again using valuation data from FINRA's Trace database). Although the hypothetical portfolio had a significantly lower duration and less volatility than the actual LQD portfolio, its average monthly returns were not significantly different than those of the actual LQD portfolio. Consequently, the hypothetical portfolio produced higher Sharpe ratios than the actual LQD portfolio over all periods measured in excess of one month, suggesting that holding the LQD index deletes for longer periods of time produces better risk-adjusted returns.
The table below compares the average monthly returns for the actual LQD portfolio and the hypothetical portfolio containing LQD index deletes. The "Extra Months" column indicates how many additional months the hypothetical portfolio was assumed to hold the LQD index deletes, with 36 months indicating that the LQD index deletes were held to maturity.
Average Monthly Returns of LQD Versus Hypothetical Portfolio
Actual LQD Portfolio
The figures in the table above illustrate the temporary impact of the three-year minimum maturity rule on the prices of LQD index deletes. While prices of the LQD index deletes are driven down during the period of time when LQD is removing them from its portfolio, they ultimately recover and produce superior risk-adjusted returns relative to the actual LQD portfolio over their remaining life.
Index Construction Influences the Investor Experience
The lesson for investors is that the rules employed by fixed-income indices can significantly influence the returns of bond ETFs that track such indices. While most traditional fixed-income indices continue to employ minimum maturity rules that negatively influence bond ETF returns, below is a list of index-based bond ETFs that track indices that retain bonds until their maturity date, minimizing the potential for price disruption caused by index front running and market-moving trades by large index-based bond ETFs.
Index-Based Bond ETFs With No Minimum Maturity Rule
Guggenheim BulletShares 2012 USD Corporate Bond ETF
Guggenheim BulletShares 2013 USD Corporate Bond ETF
Guggenheim BulletShares 2014 USD Corporate Bond ETF
Guggenheim BulletShares 2015 USD Corporate Bond ETF
Guggenheim BulletShares 2016 USD Corporate Bond ETF
Guggenheim BulletShares 2017 USD Corporate Bond ETF
Guggenheim BulletShares 2012 High Yield Corporate Bond ETF
Guggenheim BulletShares 2013 High Yield Corporate Bond ETF
Guggenheim BulletShares 2014 High Yield Corporate Bond ETF
Guggenheim BulletShares 2015 High Yield Corporate Bond ETF
PIMCO 0-5 Year US High Yield Corporate Bond Index Fund
Disclosure: I am long BSCC .
Additional disclosure: My company develops, calculates and disseminates fixed income indices that seek to track the returns of held-to-maturity bonds.
See also A Bookmaker's Approach To Inflation on seekingalpha.com