Constructing Portfolios of Constant-Maturity Fixed-Income ETFs

In this paper we address the differences in managing risk for constant-maturity fixed-income indices and traditional fixed-income portfolios. Traditional risk measures include duration, however the consistent turn over and re-investment nature of constant-maturity indices creates a complicated relationship between yield and duration. We derive that Sharpe optimal portfolios can be found based on a simple yield-to-risk framework where risk is quantified as the volatility of the underlying driving interest rate factor scaled by duration.

At Newfound, we're big fans of using simple heuristics.  Our simplified framework assumed in this paper allows us to derive the very simple "yield-to-volatility" metric that captures the balance between yield re-investment, duration and interest rate volatility for constant-maturity indices.

Of course, a simplified, theoretical heuristic is only as good as its empirical results.  Without further adieu, a quick highlight reel of the empirical evidence!

First, we find that when constant-maturity, rate-based portfolios are sorted based on yield-to-risk, they are also sorted based on Sharpe ratio -- which is exactly what we derive in the paper: the optimal yield-to-risk portfolio should also be Sharpe optimal!

Second, for a basket of fixed-income ETFs (many constant-maturity, a handful less explicitly, and several with interest rate and credit sensitivity) we find that portfolios sorted based on yield-to-risk still maintain their Sharpe ratio sorting (though, with less statistical significance).

We hope you'll give the paper a read and let us know what you think!

Corey Hoffstein

Corey is co-founder and Chief Investment Officer of Newfound Research, a quantitative asset manager offering a suite of separately managed accounts and mutual funds. At Newfound, Corey is responsible for portfolio management, investment research, strategy development, and communication of the firm's views to clients.

Prior to offering asset management services, Newfound licensed research from the quantitative investment models developed by Corey. At peak, this research helped steer the tactical allocation decisions for upwards of $10bn.

Corey is a frequent speaker on industry panels and contributes to ETF.com, ETF Trends, and Forbes.com’s Great Speculations blog. He was named a 2014 ETF All Star by ETF.com.

Corey holds a Master of Science in Computational Finance from Carnegie Mellon University and a Bachelor of Science in Computer Science, cum laude, from Cornell University.

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