We recently talked with Bryce Doty, Senior Vice President and Senior Portfolio Manager at Sit Investment Associates, Inc., about his company’s Sit Rising Rate ETF (RISE ). Doty joined Sit in November 1995.
ETF Database (ETFdb): Until very recently, Sit Investment Associates didn’t have an ETF that let investors hedge their bond portfolios. Could you describe the trajectory to creating the Sit Rising Rate ETF, and why Sit Investment Associates decided to launch it?
Bryce Doty (B.D.): We manage institutional money, but mostly manage mutual funds, and we have this RISE ETF, of course. I have been here for 20 years, and I manage about $6 billion in bonds, and we have $14 billion in the whole firm. For institutional clients, we produce or manage the strategy with -10 years duration to help them hedge their bond portfolios for the last three years. We just recently took that institutional product and put it in an ETF wrapper to make it more available to the retail world – or anyone. It actually has better liquidity characteristics than our private institutional strategy. People can use it is as-needed to modify their interest rate risk. The duration of the fund is rebalanced every month to a target of -10 years.
Call up the RISE rate website. That might help to better visualize how RISE works. On the calculator, input these things; let’s just hypothetically put in 5% for the yield in the top box and for the duration use 10 years, and start out with 0% in the (RISE) ETF, then press the calculate button. Then scroll down; there are four different scenarios. The first row has rates remain unchanged and obviously, you collect your 5% income; but with just a 1% rise in rates, you lose all your income plus another 5% from the price change.
So now go back up and put 50% in RISE in the third box. You put half in your positive 10 years and half in your negative 10 years and hit calculate. Right beneath the calculate button is the new yield, which is only 1%, and the duration drops to zero. In the previous scenario, when your duration is 10 years with only 5% of income, your interest rate risk is twice what your income is. It would have been a terrible ratio of risk to reward. But now, your interest rate risk is zero but you still have some positive income – a way better ratio of risk to yield.
Now, let’s use a more realistic portfolio. Input 4% as the yield and for years of duration, just put 5. Now start by putting 0% in RISE and hit calculate. Right below the blue button, the yield is less than a year’s duration. That’s the problem with all bond portfolios: The yields are just so low that it doesn’t provide enough income to protect you against any rise in rate. … So in 2013, for about six months, rates went up over 1%; it wiped out the whole year’s worth of income. Now just go back and put 15% in RISE in the third box and hit calculate, and this, I think, is a much better ratio. It’s a tiny weight in rise, and it’s not disruptive to your main bond portfolio. You only have to put a little cash together – maybe sell a little bit of your bond portfolio – to go into RISE, and you will still end up with almost 3% yield; but now, your duration is less than the yield. So if rates go up by a whole percentage, you at least have positive returns and your clients won’t fire you. They look at you and say, “OK. At least you did something to try and protect (me).”
That’s just the minimal amount. But say a Fed meeting or really important employment report comes. Maybe you just bump that up a little bit to 25%. Then you shave your duration all the way to one-and-a-quarter years. We actually did that. Before the September Fed meeting, we didn’t completely hedge out all the risk, but we just saw that for a client who allows us to do this, why don’t we just hedge a little more. We had taken out highest and lowest in the middle of all this volatility, and you can imagine no one is complaining.
The other thing I am nervous about clients doing is shorting duration, thinking that they are going to be safer. But when the Fed does finally move rates, their portfolios will be in the worst part of the curve. If you are shorting the portfolio into the two to four or two to five year part of the curve, that’s probably where the yields are going to go up the most, and there is hardly any income to protect you. What we have done in this fund is focus primarily on the two- and five-year parts of the curve. So 85% of the 10 years of duration comes from shorting futures and options of the two- and five-year treasury options and futures. So it really directs the protection to exactly what people are afraid of. The calculator – where it states the new yield of the bond portfolio – takes into account all RISE’s costs. It’s already embedded so you don’t need to think about that. When people think the Fed is not going to do anything, that’s when they add RISE – because that’s when it’s cheap, yields are low and obviously, that’s when there is going to be surprise on the upside. Also, you may have a really good game position in your traditional bond portfolio. Now is the time to lock that in, but some people think they are not going to worry until they are sure the Fed’s raise rates. That’s not the right way to think of it. You should think of RISE as collision insurance – you want to have it before the accident actually happens.
ETFdb: Looks like RISE has been declining in value since the inception date on February 19, 2015. Could you explain this decline? Is it because interest rates remained steady for this time period and RISE only increases in value when interest rates rise?
B.D.: You need to look at it in combination with your bond portfolio. If you were to have 15% in RISE and 85% in a bond portfolio, on a risk-adjusted basis, the combined portfolio would look great. But when you just split out RISE or you just split out the bond portfolio, both will look vulnerable.
ETFdb: Could you describe how your strategy for the RISE ETF increases the yield-to-risk ratio?
B.D.: That’s a very good question. The way I look at it, kind of the way my institutional clients are looking at it, is that they are looking at how much duration, how much negative duration I am getting for those least amount of expenses. With RISE, you get a really large negative 10-year duration for only 2% to 3% total embedded annual cost. Whereas a lot of times at that part of the yield curve, you cannot get enough bang for your buck. That’s how I look at the value on this fund. How much negative duration can I get with the least amount of cost? And with the RISE calculator, you can even put in other ETFs, look at their yields and durations, and pick and choose: “Well, this can be a fund to combine with the XYZ ETF.” There are a lot of ETFs that are newer ones that have come out with the embedded duration protection already in their portfolios. So they are buying the bonds and doing the hedge. But with RISE, you can pick whichever bond ETF and hedge however much of the interest rate risk you want.
ETFdb: What type of investor should invest in the Sit Rising Rate ETF?
B.D.: It’s funny; people are using it differently than what we thought. Some use it just to speculate – that’s a minority though. Some may speculate how the market is going to react to the employment numbers. Speculate how the market is going to react to the Fed; betting with or against them depending on their portfolio. Then there is a natural portfolio hedge – and this is the majority of our clients. They just decide that they want to own enough of something to reduce risk by the equivalent of one year, and some say, “Now, I want to take two years off.” Or, “OK. Now I don’t worry about the Fed. I’ll my duration go back out a year.” With RISE, investors can fine-tune their overall interest rate risk. And I think other people just want to lock in what they have. They say, “I do not want to pay capital gains tax on my bond, I am not going to sell all my bond portfolio and go into short-duration portfolio. I just want to lock in what I have, so as bonds mature, just add it to this hedge and keep it as is.”
ETFdb: There’s a lot of talk about a potential interest rate rise in the markets. As you know, during the FOMC minutes meeting, Janet Yellen talked about a potential interest rate rise by the Fed before end of year, possibly in December. What’s your view on the next interest rate rise?
B.D.: Well, T-bills got issued at 0% just a couple of weeks ago. We have a fund that uses the modest amount leverage in every single repo financing provider for us. Every single bank raises the rate they are charging us to finance these bonds exactly the same amount. Every single one of them, for three-month repo, raises the rate 20 basis point. That’s kind of fishy. Sounds like they’ve been talking to the Fed. Certain things like that keep me nervous about what the Fed’s going to do. They say one thing, the futures market says one thing. But these banks are operating banks; they are not investors. They are running their businesses and are managing their balance sheets. They all have their repo rate go up after not raising it or moving it for over five years. It tells me something is probably going to happen sooner rather than later.
ETFdb: Do you believe a 25 basis point increase will make a big difference for the U.S. bond market, as well as the global bond market and the economy in general?
B.D.: I do not. I think it will normalize the money market; it will reduce the incentive for banks to horde their cash and keep an excessive amount of reserves at the Fed because they currently get 25 basis points there. It will reduce that distortion, while also reducing the amount of leverage out there. But will it change the economy drastically? I wouldn’t think so. When you look at the crash in commodity prices, I understand higher rates may hurt the energy and some other sectors, but it’s also stimulative for everyone else. So you can’t just look at a glass being half empty from a reduction in commodity prices. You have to look at all of the pieces.
ETFdb: If rates do begin to rise in the near future, do you think more interest rate hikes are likely to follow?
B.D.: I expect the Fed to raise rates a quarter percent in December, skip January and raise rates another quarter percent in March. Then, they will just wait and see how the economy and financial markets will react.
ETFdb: There’s talk in the markets about another stimulus package by the Fed. Do you believe the Federal Reserve will implement more monetary stimulus?
B.D.: I do not. I think that there are enough positive economic indications that they feel they don’t need to. A lot of people talk about how the employment rate looks good but the underemployment rate is still too high at 10%. Meaning that people may not have the kind of job they really want. I don’t know what the optimal underemployment rate is, so when I see the economists talk about that, I go, “Well, why don’t we just see what people think about their employment situation – we look at the confidence data and confidence is high.” We are certainly not in crisis mode anymore.
The Bottom Line
With the imminent threat of a rising-rate environment in the near future, the RISE ETF is a great way to hedge some of that interest rate risk away. Bryce Doty of Sit Investment Associates, Inc. recommends looking at this ETF in the context of one’s overall portfolio and bond exposure. He shows that the reward-risk ratio is higher when investors include RISE in their bond portfolios.
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