When are short-term US Treasury funds (ETF or mutual) a good investment?

Question

I want to understand the rationale behind buying into a short-term Treasury ETF (or mutual fund). In particular, I want to understand how it compares to buying short-term Treasury bonds/bills directly or placing the money in a savings account. For example, I'm thinking of Vanguard's Short-Term Treasury Index ETF (VGSH) or iShares' 1-3 Year Treasury Bond ETF (SHY). Do these ETFs have different different inflation risk and/or interest rate risk profiles than Treasury bonds/bills or savings accounts?

One difference I see is that the nominal return of Treasury bonds/bills is fixed once they're purchased. For a savings account, the principal is fixed, but the interest rate can vary (incrementally). Meanwhile, the both the value and the dividends of those ETFs fluctuate.

Answer 1

It's easy to compare the ETFs you mention vs savings accounts so lets start there. The first thing to notice is the differences in yield on short term treasury ETFs vs high yield savings are not huge but large enough to be noticeable over time. As you mentioned the price of those ETFs can fluctuate but they fluctuate such a tiny amount (say compared with stocks) that it can usually be ignored. The more important difference is that there can be higher costs associated with the ETFs depending on how you trade them. The ETFs will often still a better deal overall in the long run but it's good to check the costs carefully.

As for comparing savings/ETFs to buying bills/bonds directly it depends a lot on which bonds/bills you buy. Longer dated bonds will have more interest rate sensitivity than than the shorted dated bonds in the ETFs you mentioned, but short duration bill should have similar interest rate risk. Remember the return is fixed when you buy but only if you hold to maturity. You never know when you might need to sell.

The main difference with buying bonds directly is that you have to pay more attention as your bonds as their risk will change over time and they will mature and you will need to buy more. The trading costs can be also higher depending on where/how you trade. The ETFs can trade more cheaply for you because of their scale. In the end, trading yourself really just involves more work and involves more chances of messing it up. So, I can't really recommend it.

Answer 2

Except in rather special circumstances, I would not expect any short term Treasuries to be as good as a diversified equity ETF. I say this mainly because of the 7% or so historical return from equities, compared to even longer term bonds of only 3.5%.[ https://www.joshuakennon.com/stocks-vs-bonds-vs-gold-returns-for-the-past-200-years/ ]

Of course, anybody who has fixed, short-term obligations which they know the cash value of and can only meet by preserving almost all of their capital will not want to risk an equity bear market. Treasuries, especially short term treasuries, such as the 1-3 year bonds you mention, and which have a known cash return, extremely low volatility and are generally assumed to be riskless, could then be ideal.

Long-term investors should expect to be better off with the higher expected compounding annual return after taking account of volatility. The Kelly criteria [ https://www.stat.berkeley.edu/~aldous/157_2016/Slides/lecture_2.pdf ] will tell you how much better off, and will even tell you the optimum proportion of your capital to invest in volatile equities, rather than safer treasuries. Except when P/Es are astronomically high so expected returns are exceptionally low, the numbers seems to me to recommend a 100% investment in equities.

The same formula, and recommendation even applies in the short term, provided the type of obligations above do not apply and the investor has a utility function which is logarithmic. [ https://www.economicshelp.org/blog/glossary/expected-utility-theory/ ]

Given the suitability of equities for both of the above, the main groups for whom Treasuries are suitable would seem to be banks, pensions funds, and other people looking after other people's money, and for which it would be unforgivable to loose money.

Since financial advisers, also come into this category, I should say that I am not such an adviser, the above is not advice, and equities can loose money. In fact, it this risk and the fact that it cannot be diversified away that gives the expectation of reward. I should also declare an interest in the above as someone who is fully invested in equities.