Any thoughts on a "Market Neutral" bond strategy?

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Jim180
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Any thoughts on a "Market Neutral" bond strategy?

Post by Jim180 » Tue Aug 20, 2013 11:12 pm

With a higher interest rate environment ahead there has been a lot of discussion here about how to deal with bond fund declines. Some investors are "staying the course", some are shortening duration, and others are even discussing CD's. I am interested in opinions on taking a market neutral (long/short) bond strategy. Anyone with the ability to buy an inverse ETF could use it. It would be one way to protect principal and still have a better yield than CD's. With interest rates still very low is there really much risk with such a strategy?

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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by Red Rover » Wed Aug 21, 2013 6:04 am

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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by z3r0c00l » Wed Aug 21, 2013 6:13 am

I don't understanding taking on that risk in bonds. Stocks are a far better place to get your fill of risk. I would go medium and avoid either extreme, because long and short are the worst for the two likely future outcomes; increasing rates or no increase in rates. Why capture the worst with half of your portfolio when you can go right down the middle and moderate both? Also, what if short durations see the greatest relative increase (100% or 200%) in rates?

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JoMoney
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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by JoMoney » Wed Aug 21, 2013 6:38 am

I'm trying to understand how the mechanics of this would work out. If you're short a stock on ex-dividend, you're going to wind up paying the dividend.
If you're short a bond / bond ETF, won't you have to pay out the coupon/yield? Won't this counteract whatever amount you're long, plus add additional fees?
I can't imagine this working out better then just being in cash or lower duration bonds .... ???
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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by SteveB3005 » Wed Aug 21, 2013 7:05 am

If you hold bonds to purely to dampen volatility and do your risk adjusting with an appropriate percentage of equities, the answer is to keep them short and the highest quality, minimizing duration risk as well.

Larry said for years the sweet spot for this was Treasuries in the 2 year range, doubt if that has changed much.

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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by nisiprius » Wed Aug 21, 2013 7:34 am

I believe that any old ordinary, intermediate-term high-grade "core" bond fund like Total Bond can be reasonably described as "market neutral," provided only your holding period is long compared with the duration. No matter what the market does, you come out pretty much OK and with returns that are pretty much in line with market returns.

What all the angst is about is concern with short-term temporary drops. Vanguard has said that e.g. Total Bond is in a category of funds "subject to low-to-moderate fluctuations in share prices. In general, such funds may be appropriate for investors with medium-term investment horizons (four to ten years)." But in the past you could get away with treating them as short-term money because they didn't fluctuate that much. Now, we see a situation where people who've ignored that statement and planning to hold "four to ten years" may find that they are converting short-term losses to permanent losses.

Well, if it's short-term money you'd better put it in a short-term bond fund and too bad about the yield curve.

Bonds have more risk and more reward than cash, less risk and less reward than stocks. I think it's delusional to suppose that there's some easy way to get the reward of bonds without taking the risk.

If staying the course in Total Bond isn't appealing, I think the obvious alternative is not to fiddling with and tweak the bond portfolio, but to take a close look at what Kevin M. and tfb have been advocating, with regard to bank CDs. The premise is that you can pretty well dodge interest risk entirely and still get returns that are not too different from a bond fund. It is, at least, something significantly different from incremental changes to bond holdings. And since bank CDs are not available to the institutional investors that constitute the bulk of the bond market, the efficient market hypothesis does not apply--bank CDs are in a separate category, useful only to retail savers, who are the beneficiaries of government policies targeting that group, so it is at least possible that they could be a better deal than bonds without violating EMH.
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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by nisiprius » Wed Aug 21, 2013 7:55 am

P.S. Given how the Vanguard Market Neutral (stock) fund has managed to combine the worst of both worlds, stock-like risk and money-market-like returns, the idea of applying this concept to bonds isn't too appealing.

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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by Gauntlet » Wed Aug 21, 2013 7:58 am

I just wanted to add how quickly and to what extent things have already changed in the bond market. For example, the yield on the 10yr Treasury is starting to push 3%. I believe it has already increased over 150 basis points (doubled!) in the last 12 months. In other words, if you have not changed your bond strategy already, now is probably is not a good time to do so. Personally, I have been half G fund and half total bond for a decade and I don't plan to change anything.

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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by Phineas J. Whoopee » Wed Aug 21, 2013 10:49 am

Inverse ETFs do not work in the way most of us would think based on their names alone. They are only useful for intra-day trading. You will have an expected loss of capital over longer periods of time.

I also share others' skepticism regarding long/short strategies but the main point is inverse ETFs don't work the way most people would think judging from the name. Please don't do it.

PJW

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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by G-Money » Wed Aug 21, 2013 12:27 pm

Jim180 wrote:I am interested in opinions on taking a market neutral (long/short) bond strategy. Anyone with the ability to buy an inverse ETF could use it. It would be one way to protect principal and still have a better yield than CD's. With interest rates still very low is there really much risk with such a strategy?
I must be missing something. Are you proposing to use a long/short strategy with bonds or with stocks?

Must of the "market neutral" funds/strategies I've seen invest (both long and short) in stocks. The idea is to go long on stocks you think will appreciate, while shorting the stocks you think will depreciate. The typical benchmark for market neutral funds is cash/T-Bills. https://personal.vanguard.com/us/funds/ ... =INT#tab=0.

The idea behind market neutral strategies could make at least theoretical sense for stocks (not IMO, but others might argue in favor of them), but I don't know how it could work for bonds. Generally speaking, bonds aren't nearly as volatile as stocks. And, when bonds do move (in either direction) due to interest rate changes, all bonds of the same maturity will generally move in the same direction.

Also, I'm not sure I understand how you'd get a better yield than CDs with this approach. The current SEC yield of Vanguard's market neutral fund is 0.00%. Also, go ahead and chart your favorite market neutral fund against Total Bond. I'd submit that TBM acts like a bond fund. Market neutral funds don't.

So, while I admittedly don't fully understand how you'd propose to implement this strategy, on the surface, it sounds to me like a very bad idea.
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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by Jim180 » Wed Aug 21, 2013 1:10 pm

G-Money wrote: I must be missing something. Are you proposing to use a long/short strategy with bonds or with stocks?
Bonds
G-Money wrote: So, while I admittedly don't fully understand how you'd propose to implement this strategy, on the surface, it sounds to me like a very bad idea.
Here's a couple of examples to show my strategy:

Example #1 - Suppose we use two ETF's 50% TLT(Long 20-yearTreasury) and 50% TBF(Short 20-YearTreasury). Whichever way interest rates go the NAV movement cancels out each other so there is no cumulative loss in NAV. We would still pick up the dividends on our long position.

Example #2- Suppose we own the Vanguard TBM . If we go perhaps 75-80% TBM and 20-25% TBF(Short 20Year Treasury) we would again protect downside risk in NAV while still collecting dividends with TBM.

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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by Phineas J. Whoopee » Wed Aug 21, 2013 1:19 pm

Jim180 wrote:
G-Money wrote: I must be missing something. Are you proposing to use a long/short strategy with bonds or with stocks?
Bonds
G-Money wrote: So, while I admittedly don't fully understand how you'd propose to implement this strategy, on the surface, it sounds to me like a very bad idea.
Here's a couple of examples to show my strategy:

Example #1 - Suppose we use two ETF's 50% TLT(Long 20-yearTreasury) and 50% TBF(Short 20-YearTreasury). Whichever way interest rates go the NAV movement cancels out each other so there is no cumulative loss in NAV. We would still pick up the dividends on our long position.
No, you won't. Read the links in my post.
Jim180 wrote:Example #2- Suppose we own the Vanguard TBM . If we go perhaps 75-80% TBM and 20-25% TBF(Short 20Year Treasury) we would again protect downside risk in NAV while still collecting dividends with TBM.
No, you won't. Read the links in my post.

Or, alternatively, knock yourself out. You've nobody's future security to lose but your dependents'.

PJW

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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by G-Money » Wed Aug 21, 2013 1:29 pm

Jim180 wrote:
G-Money wrote: I must be missing something. Are you proposing to use a long/short strategy with bonds or with stocks?
Bonds
That's what I was afraid of.
Jim180 wrote:
G-Money wrote: So, while I admittedly don't fully understand how you'd propose to implement this strategy, on the surface, it sounds to me like a very bad idea.
Here's a couple of examples to show my strategy:

Example #1 - Suppose we use two ETF's 50% TLT(Long 20-yearTreasury) and 50% TBF(Short 20-YearTreasury). Whichever way interest rates go the NAV movement cancels out each other so there is no cumulative loss in NAV. We would still pick up the dividends on our long position.
But you'll be paying the dividends on the short position. You'll also have the borrowing costs incurred by TBF to maintain its short position. So, before borrowing costs, your net yield of being long 20+ Treasuries and short 20+ Treasuries in equal amounts would be 0.00%. After accounting for borrowing costs on the short position, your yield would actually be negative.

Read the links provided upthread about how these short funds work. They're not designed for holding more than 1 day.
Jim180 wrote:Example #2- Suppose we own the Vanguard TBM . If we go perhaps 75-80% TBM and 20-25% TBF(Short 20Year Treasury) we would again protect downside risk in NAV while still collecting dividends with TBM.
This becomes a bet on the yield curve and credit quality. How do you anticipate you'd come out ahead using this strategy, rather than a long-only strategy? Alternatively, how is being long TBM and short long-term bonds any different than just being long a shorter-duration bond fund, like, say short-term bond index (other than the short-term bond fund will have much lower costs)?

I'm far from an expert on how market-neutral strategies or how these short funds/ETFs work, but from reading your description, I suspect you don't fully understand these things either. I think much more research is in order (not just this thread on Bogleheads) before attempting anything like this.

Good luck.
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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by stratton » Wed Aug 21, 2013 3:17 pm

There appears to be three ETFs that do this.

http://www.bogleheads.org/forum/viewtop ... 0&t=121920

Using leveraged ETFs is not a good idea as they are based on daily volatility and they can wander all over the place. It was entertaining watching a 2x REIT short fund lose more money than the REIT index it was shorting.

Paul
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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by G-Money » Wed Aug 21, 2013 3:25 pm

stratton wrote:There appears to be three ETFs that do this.

http://www.bogleheads.org/forum/viewtop ... 0&t=121920

Using leveraged ETFs is not a good idea as they are based on daily volatility and they can wander all over the place. It was entertaining watching a 2x REIT short fund lose more money than the REIT index it was shorting.

Paul
Yes, but note the ETFs referenced in that article are long corporate bonds and short Treasuries. So they are essentially trying to gain exposure to credit risk without interest rate risk.

The OP is proposing to either hold equal amounts of ETFs that are long and short 20+ year Treasuries (an approach which has a negative expected return), or going long TBM and short a smaller amount of 20+ year Treasuries, which strikes me as a complicated and more expensive way of obtaining roughly the same risk exposure as a short-term bond fund.
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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by stratton » Wed Aug 21, 2013 3:32 pm

G-Money wrote:The OP is proposing to either hold equal amounts of ETFs that are long and short 20+ year Treasuries (an approach which has a negative expected return), or going long TBM and short a smaller amount of 20+ year Treasuries, which strikes me as a complicated and more expensive way of obtaining roughly the same risk exposure as a short-term bond fund.
Sounds like a great way to lose money. What if interest rates fluctuate down for awhile?

Egypt could totally run off the rails and block the Suez Canal as one example. Greece needs more money...

The short term bond fund is a better deal. So are probably any of the three long/short ETFs.

Paul
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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by Jim180 » Wed Aug 21, 2013 4:15 pm

G-Money wrote:
The OP is proposing to either hold equal amounts of ETFs that are long and short 20+ year Treasuries (an approach which has a negative expected return), or going long TBM and short a smaller amount of 20+ year Treasuries, which strikes me as a complicated and more expensive way of obtaining roughly the same risk exposure as a short-term bond fund.
Yes, perhaps my percentage mixture of 50/50 long/short was not correct.I was not aware that I must PAY dividends with my short position. 50/50 would then equal a negative return as you point out.

Here is a link from Pro Shares that explains the strategy mentioned in my original post:
http://www.proshares.com/media/document ... d_risk.pdf

Perhaps "Market Neutral" was not the proper term. "Hedging" is more correct

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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by G-Money » Wed Aug 21, 2013 8:15 pm

Thanks for providing the ProShares link.

I still think it's a very bad idea. Take the hedging example provided on page 3. The result of having a $100,000 long position in bonds with a duration of 6 years and a $10,000 short position in bonds with duration of 7.6 years gives you the net equivalent of a long position with duration of 4.8 years. But why would you do this, instead of just using a bond fund with a duration of 4.8 years? The latter will be much cheaper. Using inverse ETFs is a clumsy and overly complicated way to do something very simple (reducing duration of your bond fund holdings). Plus, as noted already (and in the article), these inverse ETFs have one day return objectives. So they aren't intended to be a long term holding.

So, to illustrate with your two examples: going 50/50 on TLT/TBF gives you a net duration of 0 years, with a negative expected return. Holding in some different ratio will just be a more expensive way of synthesizing a short te Treasury fund.

Your example #2 will be much the same. 80/20 total bond/TBF will have a duration of less than 1 year (0.8 x 5.4 years + 0.2 x -18 years = 0.72 years). To achieve that, you could just as easily use a short-term bond fund (or a 1-2 year CD ladder), or even just use a money market or savings account.

The point is that this strategy is not a magic bullet. Just an overly complex, too-expensive means of reducing your interest rate risk.
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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by Jim180 » Wed Aug 21, 2013 8:39 pm

G-Money wrote: The point is that this strategy is not a magic bullet. Just an overly complex, too-expensive means of reducing your interest rate risk.
I appreciate your input on the topic. I think what the link was pointing out is that if a person is holding a long-term or intermediate-term bond fund in a taxable account they would have to sell the fund to significantly reduce duration. That sale would most likely cause a substantial capital gains tax, given the bond run-up in recent years. By buying an inverse ETF however would allow a person to reduce duration without triggering a taxable event.

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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by Jebediah » Wed Aug 21, 2013 8:50 pm

Not totally sure, but I don't think you need to pay the bond interest when your're in an inverse ETF like you do a short position. The trouble with the strategy is slippage-- inverse ETFs are only accurate over a one day time span. When held for longer, the tracking drifts, they leak money. You can do the math to prove to yourself why this is, I don't remember the mechanics of it off hand though.

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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by wintermute » Wed Aug 21, 2013 9:08 pm

Jim180 wrote:By buying an inverse ETF however would allow a person to reduce duration without triggering a taxable event.
No it wouldn't, as others have pointed out, because short and leveraged ETF's reset their position each day. That is very different from setting it once, at a time of purchase. When you buy an ETF they're not opening a buy-time position for you. Think about it. How could they do a purchase-time releverage for each buyer? It's impossible.

You would have to have a margin account and personally short it. The only alternative would be the creation of a fund with its own ticker just for you. That would be an impractical way to get around having a margin account, which seems to be a secondary goal of your proposal.

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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by G-Money » Wed Aug 21, 2013 9:31 pm

Jebediah wrote:Not totally sure, but I don't think you need to pay the bond interest when your're in an inverse ETF like you do a short position.
If you're short a security when it pays a dividend, you are on the hook to pay the dividend. http://en.m.wikipedia.org/wiki/Short_(finance). I don't know enough about the ins and outs of inverse funds/ETFs, but I'd be surprised if there was a way to avoid this.
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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by Jim180 » Wed Aug 21, 2013 9:52 pm

G-Money wrote: If you're short a security when it pays a dividend, you are on the hook to pay the dividend.
That is true, but looking at the price history of inverse ETF's I don't see any ex-dividend date listed. As many have pointed out these inverse ETF's adjust each day so they don't match the "long" position exactly over time. But here's the performance YTD of both TLT and TBF:
TLT (-15.72%)- Long 20 Yr Treasury
TBF +14.36% - Short 20 Yr Treasury
So YTD there is a discrepancy of 1.36%. Not really significant IMO.

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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by G-Money » Wed Aug 21, 2013 10:06 pm

Jim180 wrote:
G-Money wrote: If you're short a security when it pays a dividend, you are on the hook to pay the dividend.
That is true, but looking at the price history of inverse ETF's I don't see any ex-dividend date listed.
I think the daily price fluctuations of these inverse funds reflects accrued interest, but, again, this really isn't in my wheelhouse. Assuming that's the case, you are, in effect, paying a prorated portion of the dividend daily.
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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by RyeWhiskey » Wed Aug 21, 2013 10:38 pm

I'm not trying to be rude, but it looks like your searching for a free lunch. My understanding is that there isn't one. If you want higher yields than CDs then you must move out on the duration of your bond fund. You can own long-term treasuries or corporates and get a decent yield but you'll have to hold the fund for 14+ years in order to realize that. I simply don't understand how adding complexity to the bond side of things gets you anything other than confusion and trouble. But maybe I just don't understand it well enough.
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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by Phineas J. Whoopee » Sun Sep 08, 2013 5:47 pm

At the risk, OK, in this case not taking a risk but just doing it, of reviving this thread, I believe inverse and leveraged ETFs typically use derivatives to synthesize their positions, so there are no short bonds, or stocks, to pay interest, or dividends, on.

Those ETFs are still only useful for intra-day trades, for institutions using intra-day strategies. Anybody who thinks they can buy and hold and get what the name implies is falling into the biggest investing trap of all: buying an instrument they don't understand. Caveat emptor.

PJW

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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by z3r0c00l » Sun Sep 08, 2013 7:45 pm

I think market neutral bonds are iBonds. Can't think of anything that works as well. You don't get much in the way of returns, and should not expect much for the zero risk.

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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by z3r0c00l » Sun Sep 08, 2013 7:46 pm

I think market neutral bonds are iBonds. Can't think of anything that works as well. You don't get much in the way of returns, and should not expect much for the zero risk.

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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by Jim180 » Sun Sep 08, 2013 10:18 pm

Phineas J. Whoopee wrote: Those ETFs are still only useful for intra-day trades, for institutions using intra-day strategies. Anybody who thinks they can buy and hold and get what the name implies is falling into the biggest investing trap of all: buying an instrument they don't understand. Caveat emptor.

PJW
I respect your opinion but I looked up performance numbers to see how the inverse ETF followed the index it was tracking. Here's what I found:

TLT YTD: -11.14% TBF(inverse)YTD: +10.25%
TLT 1 Year: -14.79% TBF 1 Year: +13.93%
TLT 3 year: +2.52% TBF 3 year: -6.38%

I assume those performance numbers on the inverse ETF are based upon buying and holding the fund for the time frame mentioned. It appears that even after 3 years the inverse ETF only has a -3.86% discrepancy. So while the inverse ETF does not perform exactly, it appears that over the 3 year period mentioned the inverse ETF generally did what it was supposed to do. Move in the opposite direction.

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Re: Any thoughts on a "Market Neutral" bond strategy?

Post by Electron » Mon Sep 09, 2013 12:15 pm

Some bond funds hedge with a short position in Treasury futures. One example is SIT Quality Income fund SQIFX. The NAV of this fund has traded within a very narrow range this year. Morningstar shows the short position as a fairly large negative cash position. The short position does appear to impact the dividend which varies month to month. The short position could change over time and even be eliminated. SQIFX is a relatively new fund that has significantly outperformed their other offering with symbol SNGVX.

There are a number of bond funds that use a variety of derivative securities. Morningstar has commented that DoubleLine Total Return is like an exquisitely spinning gyroscope. The portfolio may contain CMOs, inverse floaters, and interest only mortgage tranches. The right balance is the key. I believe the two taxable bond funds at SIT have some of the same characteristics. Some of these funds will show a fairly long average maturity combined with a very low duration. The low duration is managed using the derivatives. Refer to the mutual fund website for that information as Morningstar calculates the two figures differently.
Electron

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