This award-winning ETF offers exposure to short-term floating rate debt

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IShares Floating Rate Bond ETF (FLEET) has a significant cost advantage over its ultra-short and floating rate bond peers. The underlying benchmark index of the exchange traded fund allows investors to gain exposure to the opportunities offered in this market segment in a profitable manner. These factors underpin the Fund’s Morningstar Bronze rating.

FLOT tracks the Bloomberg Barclays US Floating Rate Note fixed rate bonds. In contrast, most funds in the Morningstar Ultra-Short Bond category invest in fixed rate corporate and government bonds with maturities of less than three years. The fund provides effective protection against rising rates, but takes moderate credit risk and loses when rates fall.

More than half of the portfolio is dedicated to the financial sector, compared to less than 25% five years ago. This concentration is a source of risk, mainly carried by the big American banks. Since 2010, these companies have issued a record amount of debt to take advantage of low rates and meet stringent post-crisis capital requirements.

BlackRock, which manages this fund, has produced a strong history of index tracking. From its creation in June 2011 until May 2019, this fund has trailed its index by 0.22% each year, a shade above its fees of 0.20%. The fund’s company holdings helped it outperform the category average. The fund’s return from inception to May 2019 of 1.31% was above the category average of 0.23%. Its risk-adjusted return, measured by the Sharpe ratio, also led the category during the same time period.

Basic view
Floating rate bonds are debt securities with variable interest payments. Their coupons typically adjust every three months to reflect changes in Libor. These instruments tend to perform well in a rising interest rate environment. In this environment, the fund’s coupons are adjusted upward, while the value of fixed rate bond funds tends to fall. In contrast, when interest rates fall, the prices of fixed rate bonds gain and the coupons of variable rate bonds are adjusted downward. Even though both groups have a short duration, they behave differently.

For a small fee, this indexed portfolio replicates the makeup of the premium floating rate bond market and reflects the collective opinions of market participants about the value of each security. But there are a few drawbacks.

The market value weighting directs the portfolio towards the largest issuers of debt securities. In the market for high quality floating rate corporate fixed income, US financial institutions have issued record debt in recent years. This is due to low rates and post-crisis regulatory changes.

The portfolio is oriented towards the financial services sector, which represented more than half of the portfolio at the end of June 2019. US bank issuers represent six of the 10 largest positions in the fund. This concentration makes the fund very vulnerable to sector risk.

Additionally, the fund focuses on the lower end of the investment grade spectrum, with significant exposure to A and BBB rated bonds. These securities, mainly bonds from the banking sector, occupy more than 60% of the portfolio. On average, the fund’s peers invest around a third of their assets in bonds rated A or BBB. While these bonds are on the lower end of the investment grade credit quality spectrum, they have a relatively low risk of default and offer a higher yield than Treasury securities with comparable terms. The balance of the assets is in best rated AAA and AA securities.

This fund has effectively replicated its index since its inception in June 2011. From its inception until May 2019, it has gained 1.32% per year, while the index has returned 1.54%. The fund’s five-year annualized return to May 2019 of 1.41% was better than 68% of its peers. This outperformance is mainly explained by its relatively aggressive credit profile. But the fund is likely to lag behind its peers during market declines when credit spreads widen.

Portfolio construction
FLOT obtains a positive process rating because it accurately represents its target universe and weights its holdings according to market value, which mitigates transaction costs. This portfolio tracks the Bloomberg Barclays US Floating Rate Note rate notes denominated in US dollars. The securities in the index have at least one month and less than five years to maturity and an outstanding face value of at least $ 300 million. Their interest payments are based on the three-month Libor, with a fixed spread. The constituents of the index mainly include securities of financial and industrial companies and securities linked to government. The fund may invest in bonds of companies, governments and non-US supranational entities from several other countries. The index is updated on the last calendar day of each month.

Costs
While there are lower cost options in the category, FLOT’s 0.20% fee is still competitive with other floating rate strategies and ranks in the lower quartile of the ultra-short bond category, earning a positive rating from the price pillar.

Alternatives
VanEck Vectors Investment Grade Floating Rate ETF (FLTR) and SPDR Bloomberg Barclays Investment Grade Floating Rate ETF (FLRN) are FLOT’s closest competitors. FLRN follows the same benchmark as FLOT but has a slightly lower fee of 0.15%. FLTR’s bogy captures a wider fringe of this market segment, as it does not limit its universe by maturity. The result is an even higher degree of concentration in the financial sector and a bias towards lower quality issues compared to FLOT and FLRN. At 0.14%, FTLR’s fees are the lowest of the group.

PIMCO Short-Term PTSHX (expense ratio: 0.45%) is an attractive, actively managed alternative. This fund is rated Silver, reflecting the promising combination of a skilled manager and a team with a multidimensional, risk-aware approach that fully utilizes the capabilities of the business. The resulting five-year annual performance through May 2019 of 1.9% beat more than 96% of its category peers.

DFA Bronze Rated One Year Fixed Income DFIHX (expense ratio: 0.17%) invests in highly rated bonds denominated in US dollars with maturities of less than two years, allowing it to take a risk of higher interest rate than many of its peers. It still offers strong downside protection as it targets higher quality bonds than most of its peers. This well-designed process should continue to provide attractive risk-adjusted performance.

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as tracking indexes for investment products, such as exchange-traded funds, sponsored by the financial institution. License fees for such use are paid by the sponsoring financial institution based primarily on the total assets of the investable product. Please click here for a list of investment products that track or have tracked a Morningstar Index. Neither Morningstar, Inc. nor its investment management division market, sell, or make any representation regarding the advisability of investing in any investment product that tracks a Morningstar Index.


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