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Mutual funds are steadily losing ground to exchange-traded funds (ETFs). But one category has remained surprisingly resilient: money market funds. It’s basically about stability and liquidity.
Still, one corner of the ETF market has increasingly begun to challenge the traditional money market fund moat: ultra-short bond ETFs.
Prices of ultra-short bond ETFs fluctuate modestly based on changes in interest rates and the underlying value of their holdings.
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But they remain among the most conservative categories in the ETF universe due to their focus on short-duration, high-quality fixed-income securities.
These ETFs can also offer advantages in intraday liquidity and portfolio transparency, as well as fees and yields.
At the same time, differences in expense ratios, credit quality, duration and portfolio construction can materially affect both risk and return.
What is an ultra-short bond ETF?
An ultra-short bond ETF is a publicly traded investment vehicle whose underlying portfolio comprises fixed-income securities with very low interest rate sensitivity.
That sensitivity is measured through duration. Duration is a metric that estimates how much a bond ETF’s net asset value (NAV) will change in response to movements in interest rates, all else being equal.
Ultra-short bond ETFs don’t maintain a fixed $1 NAV like money market funds, so there’s still some principal risk. In practice, price fluctuations tend to be modest.
Duration is an important factor to consider amid persistent uncertainty about inflation. When inflation surged in 2022 and central banks rapidly raised rates, many investors discovered that long-duration bond funds could experience large losses.
The exact definition of “ultra short” varies among providers, but generally refers to bond ETFs maintaining an average effective duration of under one year.
Many ultra-short bond ETFs focus on investment-grade securities, while others venture into non-investment-grade or high-yield bonds, also known as junk bonds, to generate higher yields. And some focus on Treasurys.
These differences matter because the issuer type and credit quality of the underlying bonds directly affect both yield and tax efficiency.
In general, corporate bonds yield more than government bonds of comparable maturity because investors demand additional compensation for accepting higher default risk.
However, corporate bond income is generally taxed as ordinary income at both the federal and state level, whereas Treasury interest is typically exempt from state and local taxes.
These two variables, duration and credit quality, are the two main levers managers pull to adjust risk and return. Even with just those two inputs, there are a surprising number of combinations possible.
How we picked the best ultra-short bond ETFs
To ensure we were truly evaluating ultra-short bond funds, we screened all candidates to confirm they maintained an average portfolio duration of one year or less.
From there, we focused heavily on fees. Most ultra-short bond ETFs will produce returns somewhere around prevailing short-term interest rates, perhaps with a modest premium depending on how much credit risk the manager is willing to assume.
That makes fees particularly important. Remember, 30-day SEC yields are quoted after deducting the expense ratio. Every additional basis point charged reduces investor returns.
As a result, we imposed a maximum expense ratio of 0.25% annually. For a $10,000 investment, that works out to no more than roughly $25 per year in fee drag.
We also considered fund size. The ultra-short bond ETF category has become increasingly crowded in recent years, and not every product launched will survive long term. We required every ETF to maintain at least $1 billion in assets under management.
Finally, we required all eligible ETFs to maintain a 30-day SEC yield above the current range for the federal funds rate of 3.50% to 3.75%.
Note that these are pre-tax yields. Because many ultra-short bond ETFs hold corporate paper, after-tax returns may be materially lower depending on your income bracket and state of residence.
Vanguard Ultra-Short Bond ETF
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- Assets under management: $8.3 billion
- Average duration: 1.0 years
- Expense ratio: 0.10%
- 30-day SEC yield: 4.3%
The Vanguard Ultra-Short Bond ETF (VUSB) is one of Vanguard’s few actively managed ETFs. While Vanguard is best known for low-cost passive indexing, the firm has made significant inroads into active fixed-income management.
Fixed income is one area where active management can potentially add more value than in equities because the bond market is more fragmented, less transparent and largely traded over the counter rather than through centralized exchanges.
Active managers can potentially exploit pricing inefficiencies, liquidity dislocations and relative value opportunities.
VUSB’s mandate is to maintain a dollar-weighted average maturity between zero and two years while investing in a diversified portfolio of high-quality short-term bonds. The portfolio includes asset-backed securities, Treasurys and investment-grade corporate bonds.
Vanguard currently rates the ETF a “1 out of 5” on its internal risk and reward scale. Even so, the firm emphasizes that VUSB shouldn’t be viewed as a direct substitute for a money market fund because the ETF still carries some degree of principal risk.
In practice, however, that volatility has historically remained fairly limited when viewed over longer periods. The combination of short-duration and high-quality underlying securities has helped keep price fluctuations relatively modest.
Learn more about VUSB at the Vanguard provider site.
iShares Ultra Short Duration Bond Active ETF
(Image credit: iShares)
- Assets under management: $7.5 billion
- Average duration: 0.8 years
- Expense ratio: 0.08%
- 30-day SEC yield: 4.1%
The iShares Ultra Short Duration Bond Active ETF (ICSH) is one of the primary competitors to VUSB. Its issuer, BlackRock, ranks alongside Vanguard among the two largest ETF providers globally by total assets.
Like VUSB, ICSH is actively managed and designed to provide relatively conservative short-duration fixed-income exposure. BlackRock has actually undercut Vanguard on fees in this category by two basis points.
The portfolio spans 242 bonds and maintains an investment-grade mandate. In practice, roughly 45% of the portfolio is allocated to A-rated bonds, while AA-rated securities represent the second-largest allocation at 36.8%. This differs somewhat from VUSB, which maintains somewhat greater exposure to BBB-rated securities.
The higher average credit quality of ICSH helps reduce credit risk, but it also modestly lowers yield potential. Even so, because the ETF still maintains meaningful exposure to corporate paper, its yield remains comfortably above the upper end of the current range for the federal funds rate.
Learn more about ICSH at the iShares provider site.
PGIM Ultra Short Bond ETF
(Image credit: PGIM)
- Assets under management: $16.2 billion
- Average duration: 0.4 years
- Expense ratio: 0.15%
- 30-day SEC yield: 4.2%
Investors willing to look beyond the large providers such as Vanguard and BlackRock may find compelling alternatives in the ultra-short bond space, including PGIM Ultra Short Bond ETF (PULS).
PULS follows a fairly straightforward strategy. Like VUSB and ICSH, it’s actively managed and seeks to outperform the ICE BofA U.S. 3-Month Treasury Bill Index. Historically, it’s generally been able to do this because, unlike the benchmark, PULS is not confined solely to Treasurys.
The portfolio spans a range of short-duration fixed-income instruments. Corporate paper currently makes up a substantial portion of holdings, but the ETF also allocates meaningfully to asset-backed securities, commercial paper, floating-rate corporate notes, mortgage-backed securities, collateralized mortgage obligations and even foreign certificates of deposit.
Despite these somewhat exotic exposures, overall credit quality remains fairly strong. The ETF’s largest allocation currently sits in AAA-rated securities at roughly 34% of assets, while the remainder is relatively evenly distributed among AA-, A- and BBB-rated holdings.
Morningstar has also viewed the ETF favorably, awarding it a Gold Medalist Rating. This rating reflects Morningstar’s forward-looking assessment of a fund’s likelihood of outperforming peers on a risk-adjusted basis over time.
Learn more about PULS at the PGIM provider site.
JPMorgan Ultra-Short Income ETF
(Image credit: Courtesy of JPMorgan)
- Assets under management: $38.1 billion
- Average duration: 0.8 years
- Expense ratio: 0.18%
- 30-day SEC yield: 4.1%
JPMorgan Asset Management is perhaps best known among ETF investors for its derivative-income products and actively managed equity strategies. However, the firm also offers several tools geared toward more conservative investors.
Chief among them is the JPMorgan Ultra-Short Income ETF (JPST), which has accumulated more assets under management than both VUSB and ICSH combined.
JPST is also actively managed. The portfolio includes just under 800 bonds, concentrated in investment-grade corporate debt, with some exposure to certificates of deposit and asset-backed securities. Credit quality is concentrated in A- and BBB-rated issues, with AAA-rated securities representing the third-largest allocation.
JPST is more expensive than VUSB, ICSH and PULS, though the difference remains fairly modest in absolute terms.
As it has for PULS, Morningstar has assigned JPST a Gold Medalist Rating, reflecting its conviction that the ETF is well positioned to outperform peers on a risk-adjusted basis over the long term.
Learn more about JPST at the JPMorgan provider site.
Invesco Ultra Short Duration ETF
(Image credit: Invesco)
- Assets under management: $3.5 billion
- Average duration: 0.6 years
- Expense ratio: 0.22%
- 30-day SEC yield: 4.2%
By now, the general structure of ultra-short bond ETFs should look fairly familiar. Most tend to be actively managed, maintain investment-grade mandates and possess broad flexibility to allocate across different types of short-duration fixed-income securities.
The Invesco Ultra Short Duration ETF (GSY) is a good example of this structure in practice. The ETF currently holds just under 400 securities. Roughly 43% of the portfolio is allocated to A-rated bonds, with the remainder spread relatively evenly across BBB-, AA- and AAA-rated securities.
Invesco also provides fairly detailed sector breakdowns for the portfolio. One thing investors will notice is that many of the underlying bonds are issued by companies in the financial and industrial sectors, alongside additional exposure to asset-backed and mortgage-backed securities.
One factor holding GSY back is cost. While the ETF is not excessively expensive in absolute terms, its 0.22% expense ratio is nearly three times higher than ICSH and more than double that of VUSB. That difference matters in the ultra-short bond category because yields are already relatively modest to begin with. Every additional basis point of fees directly reduces investor income.
Still, despite the higher fee structure, GSY’s 30-day SEC yield remains broadly competitive with many of the other ultra-short bond ETFs profiled here. For investors seeking another actively managed option with diversified short-duration exposure, it remains a viable alternative.
Learn more about GSY at the Invesco provider site.