Fixed IncomeApr 13 2017

DFMs ramp up bond ETF exposure

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DFMs ramp up bond ETF exposure
Bond ETF flows in 2016

Discretionary fund managers (DFMs) have begun to swap direct bond holdings for passive exposure as the rise of fixed income exchange-traded funds (ETFs) creates an alternative to traditional methods of investment. 

DFM portfolios have long included individual shares and bonds, and interest in direct equity investments is rising again after years of being superseded by fund structures. Wealth manager Thesis is among those to have swapped funds for shares in a bid to lower costs. Multi-managers, too, have gone direct to alleviate fee pressure. 

In the bond space, however, the rise of passive fixed income vehicles is producing a different dynamic. Hector Kilpatrick, chief investment officer at Cornelian Asset Manager, said the firm was looking at exchanging some of its direct bond holdings for ETFs. 

“For our original risk-managed fund range we hold government debt directly in the funds. All our other fixed income investments are outsourced to third-party active fund managers,” he said. 

“Our original risk-managed fund range does not currently hold any fixed income ETFs, but we are actively considering adding one or two in the not too distant future, given our work in identifying good passive bond products [for other portfolios].” 

As a result, passive providers are eyeing DFMs as a source of growth for their nascent bond offerings. Joe Parkin, head of UK retail and wealth at ETF provider iShares, said fixed income had been a focus of demand from DFMs recently, in part because of the costs involved in buying bonds directly. 

“There’s a large amount of direct bonds sitting with wealth managers. We have seen a shift, with them being exchanged for a fixed income ETF,” he said.

Others favouring a lower-cost option said they have turned to ETFs in a number of markets because of the difficulties replicating exposure independently. Ben Kumar, of Seven Investment Management, said that while the firm invests directly in developed market government bonds, it relies on ETFs elsewhere. 

“ETFs are really useful in areas where the index is much broader,” he said. “We could buy UK corporate bonds to track the iBoxx index but there are about 500 bonds in there.”

There are other complications in managing fixed income exposure directly, such as managing bonds close to maturity, and, in many cases, significant minimum investment levels, which can prevent the creation of a diversified portfolio. 

In some cases, concerns about cost are not enough to drive investors away from active managers in the space. 

Ben Conway, a manager at Hawksmoor, believes that illiquidity and the limited resources of a multi-asset manager are good reasons to avoid both ETFs and direct holdings.

“ETFs are most suitable when the underlying asset is in an extremely deep, liquid market,” he said. “If you directly invest in bonds why not do it everywhere? You don’t have the time or expertise. The skillset of ours is asset allocation and manager selection.” 

Bond ETFs took in E20.6bn (£17.5bn) in net flows across Europe last year, beating their equity counterparts for the first time, according to Morningstar. Figures from Lipper indicate that fixed income ETFs now account for 26 per cent of the overall European ETF market, though this is still dwarfed by equity products’ 69 per cent market share.