Fixed IncomeJul 9 2013

Are fixed income ETFs the next big thing?

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It took quite some time for passive equity investing to catch on in the UK but, now that it’s here, it has built up an ever-growing position and a following amongst investors. But fixed income passive funds, particularly exchange traded funds (ETFs), have been slower to catch on.

Stephen Cohen, head of EMEA investment strategy and insight at iShares, BlackRock’s ETF business, believes that the disparity between the pick-up in ETFs is down to the fact that “ETFs look like an equity and trades like one”, so equity ETFs were easier for investors to get their heads around.

Fixed income exchange traded products still make up only around 3 per cent of the market, and just 17 per cent of all exchange traded assets, with equities making up 75 per cent.

However, the popularity of fixed income ETFs has grown hugely since the 2008 financial crisis, partly down to the increased focus on investment costs that has also benefited equity ETFs, but also because of the liquidity that is available to investors from a fixed income ETF.

Liquidity

Huge numbers of investors in fixed income funds found themselves trapped during the financial crisis because the liquidity in the funds was not good enough to keep up with the redemptions and forced selling that rocked the fixed income marketplace.

ETFs are seen as more liquid than conventional fixed income funds and Mr Cohen said he had been seeing a lot more demand for ETFs due to concerns about liquidity in other fixed income products.

According to Mr Cohen, those investors who did move into exchange traded fixed income funds were vindicated in the most recent market sell-off, when almost every asset class sold off at the same time.

He says: “There has not been a lot of liquidity in the sell-off but you have seen liquidity in the ETF marketplace, even though they were record volumes in high yield ETFs in recent weeks.”

There have been concerns raised that ETFs are contributing to increasing volatility in the market, but at only 3 per cent of the fixed income market at the present, fixed income ETFs most likely do not have that clout yet.

There is also an argument for accessing fixed income through an ETF in the same way that there is for buying passive equities; over the long run, academic research has shown that fixed income ETFs outperform the average active manager.

Costs for fixed income ETFs are also much lower than actively managed bond funds, with annual management fees dipping as low as 0.1 per cent or 0.2 per cent for a traditional gilt ETF tracker, although dealing costs need to be taken into account for smaller sums invested.

Concentration

There are also an increasing range of markets covered by fixed income exchange-traded funds, according to Peter Sleep, senior investment manager at Seven Investment Management.

“Like equity ETFs, fixed income ETFs are pretty good value and have a range of choices, so you can have a plain gilt ETF or something like an emerging market Asian corporate bond ETF,” says Mr Sleep.

In spite of this increasing range of products, there are a limited number of providers that are actually producing these products.

ETF managers such as State Street, Source and Lyxor all have fixed income ETFs, but iShares is the dominant player in the market, regularly bringing in 75 per cent of all new flows into the market, according to Mr Sleep.

Worries about the dominant position that iShares was building up in the ETF marketplace, particularly the physically-backed ETF market, caused the Office of Fair Trading to recently conduct a review of iShares’ acquisition of Credit Suisse’s ETF business, looking at whether it would distort prices and competition in the marketplace.

However, the deal was cleared to go ahead and iShares remains the pre-eminent fixed income ETF provider, with the most assets under management, which gives it a particular edge when one of the main benefits of using a fixed income ETF is liquidity.

Innovation

However, there are new products being set up under names as varied as smart beta, smart passive or new beta. These are products that do not exactly follow a traditional market capitalisation-weighted index, but instead follow different strategies.

In equity ETFs, these strategies include following such things as equal weighted indices, where the fund has an equal amount in every stock on the index. In fixed income ETFs, the new beta products are such things as GDP-weighted indices.

These ETFs can get around the problem of fixed income indices being dominated by the most indebted countries or companies, which means that investors buying into these traditional indices have a disproportionate exposure to companies or countries that may not have the best debt dynamics.

Mr Sleep explains: “Think of eurozone market, where the biggest borrower is Italy, which is also globally the number three issuer.”

For Mr Sleep, investing in smart beta products helps to overcome precisely this kind of problem, that of being overly exposed to a country, Italy, that has a high debt-to-GDP ratio, recently saw its 10 year government bond yields rise over the dangerous level 7 per cent and is having to put in place serious reforms to stand any chance of stimulating long-term growth.

These alternative index funds are still in their infancy for fixed income EFs, with few products available right now, but it looks set to be a growing trend in the market, and will lead to even more options for investors looking at fixed income ETFs.