With the Fed looking like it’s finally going to begin tightening policy in 2022, investors will need to continue searching for solutions that can potentially make money in a rising rate environment. FolioBeyond and its CEO Yung Lim believe they have such a product. His company’s FolioBeyond Rising Rates ETF (RISR) offers a distinct strategy that is designed to seek to benefit from higher rates while delivering income. Lim joined the ETF Think Tank to discuss his fund and his outlook on the fixed income space.
RISR invests primarily in interest-only MBS (MBS IO), so the natural question is what are these securities and how can they be expected to perform. MBS IOs strip out the interest payments from the underlying security and end up getting bought and sold as individual securities themselves. The interest only (IOs) securities carry a negative duration and can potentially be a great interest rate hedge for a diversified portfolio. Lim believes that this negative duration1 aspect of his fund could potentially do well if the Fed follows through on rising interest rates and the Treasury yield curve follows suit.
Lim also notes that when rates go down, IO values have tended to fall because you anticipate greater refinances and pay-downs of existing mortgages. Since the IOs generate interest income, they can be a great tool for income investors who want to capture a yield while hedging against rising rates.
While IOs can be thought of as more of a defensive asset, there are some potential tail risks involved. Lim says that interest rate volatility, like what we’ve seen over the past week or two, can impact his fund. It takes some time for prepayment activity to work through the system and prepayments will be impacted by how primary mortgage rates respond when there’s a bigger move down in interest rates. The structure of the portfolio plays a key role in how the fund performs.
There’s also the potential risk of what might happen when the Fed begins tapering its asset purchase program and removes its support of the market. In theory, the central bank raising interest rates should be good for IOs but there’s also the issue of how MBS spreads would behave relative to Treasury yields. There’s a good chance, Lim says, that widening spreads would have the effect of slowing prepayments and this could further benefit IOs.
Other key takeaways:
- What did trading look like during the first week of the year when rates were spiking? Lim says that his fund isn’t involved in active rebalancing unless there’s a bigger rate move, for example, of around 50 basis points2 or more. The RISR portfolio has tended not to change dramatically.
- Lim says that his company chose to launch RISR as an ETF instead of a mutual fund because of the tax efficiency and transparency benefits of the ETF structure. He also felt that the mutual fund wrapper and its once-a-day pricing would be a disservice to investors.
- FolioBeyond also uses artificial intelligence in developing some of its portfolio solutions, but currently limits its use to the equity side, particularly with equity income strategies. The company uses portfolio optimization techniques for fixed income solutions.
1Duration: Duration is a measure of the relationship between interest rates and price for a fixed income security. Positive duration refers to a relationship whereby prices decline as interest rates rise, while negative duration refers to a relationship whereby prices increase as interest rates rise.
2Basis Point: One hundredth of one percent, used chiefly in expressing differences of interest rates.
Disclosure
Investors should consider the investment objectives, risks, charges and expenses carefully before investing. For a prospectus or summary prospectus with this and other information about the Fund, please call (866) 497-4963 or visit our website at www.etfs.foliobeyond.com. Read the prospectus or summary prospectus carefully before investing.
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.
Opinions expressed are subject to change and should not be considered investment advice.
MBS. Mortgage-backed securities are fixed-income instruments that represent an interest in a pool of mortgages.
MBS IOs. MBS IOs represent the interest portion of the MBS.
RISR is distributed by Foreside Fund Services, LLC, advised by Toroso Investments, LLC, and sub advised by FolioBeyond, LLC.
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