In 2011, ETFs Bond with Treasuries

Did you have the foresight to invest heavily for your clients in Pacific Investment Management Co.'s 25-year zero-coupon U.S. Treasury exchange-traded bond fund, one year ago?

Probably not.

But you would have been in fine company. Probably the best-known investor who bet against U.S. Treasury bonds in 2011 was Bill Gross.

Gross is founder and co-chief investment officer of ... PIMCO. He runs the PIMCO Total Return Fund, the world's largest mutual fund, which reported assets of $242.7 billion at the end of June 2011.

But that fund, which invests in high-quality bonds, was flat for the year, its net asset value climbing to $10.87 a share, from $10.85. By year's end, investors had pulled out $5 billion, according to Morningstar research. This was the first year since its founding in 1987 the fund failed to attract fresh capital.

But if you had bet on the PIMCO 25-year zero coupon Treasury ETF one year ago, you would have gained 51.9% on your investment. The fund, with the symbol ZROZ, was the best-performing exchange-traded fund in 2011.

Yet ZROZ was not the only winner, in the U.S. Treasuries sweepstakes. All eight of the best-performing ETFs offered some sort of spin on U.S. debt.

These included the Vanguard Extended Duration Treasury fund, the iPath U.S. Treasury 10-Year Bull note, the iPath U.S. Treasury Long Bond Bull note, the iShares Barclays 20+ Year Treasury Bond fund, among others.

These were funds that did not try to apply leverage to their bets on Treasury bonds. If you tried that, you would have done even better. The PowerShares DB 3X Long 25+ Treasury Bond ETN and Direxion Daily 20 Year Plus Treasury Bull 3x Shares funds each more than doubled in value.

The moral of the story:

When investors are worrying whether European countries can meet their obligations, put your money in the United States' obligations. Even if U.S. debt is not looking nearly as healthy as a decade ago.

Stocks? Fahgeddaboutdem.

The biggest gains were in funds that invested in instruments that paid interest or dividends. Fixed-income funds, which started the year with $136.7 billion in assets, grew by about a third, according to Anthony Rochte, senior managing director at State Street Global Advisors.

"Clearly, where we saw the demand was (in) a movement toward dividend-paying or income-oriented vehicles, regardless of the ETFs," Rochte said.

"It wasn't a banner year for equities," said Daniel Waldron, senior vice president and ETF strategist of First Trust, a Wheaton, Ill., provider of products and services to financial advisors. The Standard & Poor's 500 Index finished the year at 1,257.60, compared to 1,257.64 at the end of 2010, for instance.

"The top-performing ETFs generally fell in the alternatives categories," Waldron said. "Those are products that are leveraged. They're either leveraged debt or leveraged equities."

Sectors that performed well were utility funds and consumer staples. Leaders there were State Street's SPDR Select Sector Fund for Utilities (XLU), which gained 15.7%, and its Consumer Staples Select Sector SPDR Fund (XLP), which gained 11.0%.

"Those are two defensive categories that are less economically sensitive, sort of 'risk-off,'" Waldron said.

Which gets into the big tradeoff of the year. With each major change in the outlook for a sustained U.S. recovery or the fate of Europe's overburdened countries, investors moved their money wildly.

"The big buzzwords in 2011 were 'risk-on' and 'risk-off.' Every time the market shifts one direction or other, investors seem to take their whole investment strategy one way or the other,'' he said.

"Risk-on" came to connote investing in economically-sensitive sectors of the economy, like retailing. "Risk-off" came to mean a condition when "everybody jumped back into the utilities, staples and other categories of the market that are more defensive,'' Waldron noted.

Also garnering interest was gold, which peaked in value in August at $1,889.70 an ounce. State Street's SPDR Gold Trust (GLD), for instance, gained more than 17%, according to Rochte.

A place not to go was funds investing in financial services firms. Betting on Bank of America, as another famed investor, John Paulson, found, was not a good idea.

State Street's SPDR Select Sector Fund for Finance (XLF), for instance, finished down 18.9% for the year.

By contrast, First Trust's own Financials AlphaDEX fund was "only" down 7.35%.

The challenge now becomes to find ways to create what Quantshares Chief Executive Officer Bill DeRoche and Executive Vice President Richard Block call "excess performance" from within well-defined sectors or investment strategies. And then set down the rules that allow the given investment theme to be carried out automatically, aka passively.

Their funds rely on spreads generated by betting long on stocks in a given category that can be expected to deliver above-average returns and to short those that won't.

In a value fund, that means betting long on securities that have below-average values based on ratios such as earnings to share price, book value to share price, and cash flow from operations to share price and shorting securities that have above-average values on the same measures.

In a quality fund, that means betting long on securities across many sectors that have high returns on equity and low debt to equity ratios and shorting the converse.

"We're giving people the opportunity to take part in strategies they didn't have available before," DeRoche said.

In a broad passive index such as the Russell 1000, for instance, "it's all about the overall market," he noted.

Not so with rule-based investing that balances out long and short bets, based on defined characteristics. Like the value Quantshares try to quantify in its CHEP exchange-traded fund.

"The biggest determinant with ours is whether cheap stocks do better than expensive stocks. Where the market goes up or down is irrelevant," Block said.

What investors are trying to find are passive ways to achieve active results. These days, that means finding asset types or fund types that do not move in lockstep with basic, broad market movements.

"What people are looking for is an investment theme or strategy that is uncorrelated to the typical stocks, bonds, commodities investment strategy," said Greg King, head of exchange-traded products at Credit Suisse.

High "correlation" of movement of securities makes one of the most fundamental of asset allocation strategies-diversification of risk-one of the hardest goals to achieve. But, King said, it's the only way to sustain above-average returns.

"Diversification is still the only free lunch," he said. "But you actually have to achieve the diversification."

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