RISR Commentary for June, 2022

Performance Summary

The FolioBeyond Rising Rates ETF (ticker: RISR) returned 1.31% based on closing market price (1.39% based on net asset value or “NAV”) in June. In comparison, the ICET7IN Index (US Treasury 7 Year Bond Inversed Index) returned 0.71% while the Bloomberg Barclays U.S. Aggregate Bond Index ("AGG") returned -1.55% during the same time period.

The performance data quoted represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than their original cost and current performance may be lower or higher than the performance quoted. Performance current to the most recent month-end can be obtained by calling 866-497-4963. Short term performance, in particular, is not a good indication of the fund’s future performance, and an investment should not be made based solely on returns. Returns beyond 1 year are annualized.

A fund's NAV is the sum of all its assets less any liabilities, divided by the number of shares outstanding. The market price is the most recent price at which the fund was traded. The fund intends to pay out income, if any, monthly. There is no guarantee these distributions will be made.

Total Expense Ratio is 1.01%.

June Activity

The volatility we noted in May was even more pronounced in June. Indeed, June was one of the most volatile months for interest rates in many years. Behind this volatility was the pendulum swings in the outlook for inflation and the economy. At times there seemed to be great concern about inflation and the trends in prices for a whole range of products. Then, at other times, the market sentiment seemed to focus on the potential for recession, at which point rates dropped sharply in just a few trading sessions.

Focusing on the 10-year US Treasury Note, interest rates started the month around 2.85%. A mere two weeks later, rates had jumped to 3.48%, before collapsing again to end the month at just about 3%. Naturally bond prices swung in the opposite direction as rates. The current on-the-run bond opened June at a price of roughly 99.75, and collapsed to a low of 94.9375, before recovering to end the month at about 98.75. For readers who are unfamiliar with typical bond price movements, we can assure you those are extreme swings in price over a 30-day period.

Despite this volatility, as noted above, RISR was able to produce a positive return that helps to continue our place in the top performing handful of non-levered fixed income ETFs for 2022. We also added assets during the month, with our assets-under-management increasing from around $115MM to around $128MM. RISR has been one of the fastest growing ETFs in the market so far this year, for which we are grateful to our investors.

Behind all this volatility is the Federal Reserve Board, and in particular, its chairman Jerome Powell. The Fed open markets committee voted to increase the Federal Funds rate by 75 basis points (“bps”) on June 15. This was widely anticipated by many observers, but still seemed to catch the market off-guard, as if they didn’t really believe the Fed would move 75 bps. In our opinion, 100 bps would have been better from a policy perspective, but from this Fed one takes what one can get.

So, while the move in rates was welcome as an inflation fighting measure, at the press conference following the rate announcement, Powell repeatedly undermined his own message. The entire session was an exercise in “other-handedness.” As in, “on the one hand we need to stop inflation,” but on the other hand, “we don’t want to cause a recession.” Readers of history may recall that President Harry Truman once demanded of his advisors that they bring him a one-handed economist, but it is believed none was ever discovered.

In any case, this kind of mixed messaging does nothing but confuse the market, and it is a big reason for the volatility observed in June. In our view, very soon the Fed will be forced by events to move away from this dual-pronged approach and will have to focus exclusively on inflation. We think it is possible we may see a double digit (i.e., greater than 10%) inflation statistic before inflation truly peaks. At that point even the most ardent two-handed Fed policy makers will have to concede that the real enemy of our time is inflation. And so, despite all the equivocations, we hold fast to our view that interest rates still have a long way higher to go.

The simple reality is the Federal Reserve absolutely has the power to reduce inflation, it simply does not yet appear to have the political will to do so. It could be achieved by raising interest rates much more aggressively than the market now expects, or the Fed policy-makers can stomach. Bringing Fed Funds to 4-5% over the next 6 months might do it, or it might not. In which case, we believe they should raise rates to 6-7%, and that the Fed will have to go there eventually. In our opinion, it is just a matter of how much long-term damage they will do to the economy by dithering. As long as inflation is running above 8%, setting interest rates at 3% will not achieve the Fed’s goals. Inflation will persist and will likely accelerate. And that means interest rates will have to go higher. We do not believe there is any alternative.

The good news is that the recent pullback in rates has provided a very welcome opportunity for current investors to add to existing positions, or for new investors to open positions, in RISR. The highest price observed for our shares to date has been $34.34 per share on June 14. At the end of the month those same shares could be purchase at $32.34, a decrease of around 5.8%. As of the date of this note, the share price has increased a bit to $32.46, so one could say the RISR strategy is still “on sale.” And this is so despite the fact that the Fed has become even more hawkish since mid-June.

As we have noted previously, our strategy aims to hold a negative 10-year duration. That is, the fund is managed to experience price movements of 10x the change in interest rates. Consequently, if rates were to rise 100bps, we would expect to see gains in NAV per share of around 10%. A 200 bps rise could see a 20% gain, and so on. Since the inception of the fund, our actual rate sensitivity has been even greater than that, due to security selection, and mortgage spread widening. We hope to be able to outperform our baseline goals, but even if we only achieve our targets, RISR investors may see material further gains if rates increase as we believe they will. This trade is far from over.

In addition, it is important to note that our investments generated a meaningful amount of current income. The fund distributed a dividend of $0.09/share in June, and so far in 2022, we have paid $0.263/share in dividends. This current investment income provides a meaningful supplement to investor returns, that may persist even if the Fed delays getting on with the job of raising rates to tame inflation.

As we have noted in the last several commentaries, the housing and mortgage markets are showing signs of significant stress. Sales of existing homes has been dropping each month this year since February. The Mortgage Bankers Association’s index of mortgage refinance applications are down over 75% year-over-year, and purchase money mortgages are down 7.8%. Construction of new homes has stagnated following the post-covid recovery and are now down 14.4% in just the last 3 months. Non-residential construction is slowing as well. We expect conditions in residential and commercial real estate to continue to deteriorate.

We don’t often discuss the stock market in these notes, but it is worth pointing out that conditions in that market are pretty terrible, especially for the tech-heavy NASDAQ which is down over 30% from its peak last November. The S&P 500 has fared a little better but is itself down over 20%. There has basically been no place to hide for investors, with the exception of RISR, in our opinion, and a handful of funds that have adopted a similar thesis. We don’t usually aim to give investors specific advice on portfolio construction since we don’t have knowledge of individual circumstances. However, we do believe that the basic market patterns seen so far this year in equities and fixed income—lackluster equity performance and further declines in fixed income values coming from rate hikes—will persist until we are fully through this cycle. We don’t see that happening until well into 2023, and it may persist into 2024, if the Fed and fiscal policy makers continue to act as ineptly as they have so far.

If this forecast is correct, then investors may look back on June 2022, as one of the best opportunities they will have had to reset hedges and structure portfolios for the tough environment we see ahead.

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.

Diversification does not eliminate the risk of experiencing investment losses.

Index Definitions

Bloomberg Barclays US Aggregate Bond Index: A broad-based benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency).

US Treasury 7-10 Yr Bond Inverse Index:
ICE U.S. Treasury 7-10 Year Bond 1X Inverse Index is designed to provide the inverse of the daily return of the ICE U.S. Treasury 7-10 Year Bond Index (IDCOT7). ICE U.S. Treasury 7-10 Year Bond Index tracks the performance of US dollar denominated sovereign debt publicly issued by the US government in its domestic market. Qualifying securities of the underlying index must have greater than or equal to seven years and less than 10 years remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and an adjusted amount outstanding of at least $300 million.

Definitions

Alpha: a return achieved above and beyond the return of a benchmark or proxy with a similar risk level.

Basis Points (bps): Is a unit of measure used in quoting yields, changes in yields or differences between yields. One basis point is equal to 0.01%, or one one-hundredth of a percent of yield and 100 basis points equals 1%.  

Beta measures: the volatility of a security or portfolio relative to an index. Less than one means lower volatility than the index; more than one means greater volatility.

Coupon: is the annual interest rate paid on a bond, expressed as a percentage of the bond’s face value.

Convexity: A measure of how the duration of a bond changes in correlation to an interest rate change. The greater the convexity of a bond the greater the exposure of interest rate risk to the portfolio.

CUSIP : An identifier  number that stands for the Committee on Uniform Securities Identification Procedures assigned to stocks and registered bonds in the United States and Canada.

Duration: measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.

GNMA: Government National Mortgage Association

FNMA: Federal National Mortgage Association

FHLMC: Federal Home Loan Mortgage Corporation

Short Investment (Shorting): is a position that has been sold with the expectation that it will decrease in value, the intention being to repurchase it later at a lower price.

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