Passive  

Choice and flexibility prompt bond inflows

This article is part of
The Guide: passive investing

Choice and flexibility prompt bond inflows

Analysis shows there has been a 954 per cent increase in global assets of fixed income exchange-traded funds (ETFs) since 2007, reaching $601bn in assets under management (AUM) at the end of 2016, with $117bn inflows last year alone.

The reason? Fixed income ETFs have evolved to become a much more sophisticated tool for investors, providing greater choice and increasingly granular exposures. At the same time, investors have identified multiple and varied uses for ETFs in their portfolios.

This trend is likely to continue, with three key factors driving this change: access, cost pressures and the widespread adoption of ETFs in general.

Firstly, in terms of access, ETF specialists have worked with index providers to create broader and more sophisticated fixed income indices, providing investors with a greater range of implementation opportunities. This includes previously unattainable areas of the market for passive products, such as high yield, convertible bonds and emerging market debt.

Secondly, over recent years ETFs have received greater attention as investors have increased their scrutiny on cost. As a result, investors have discovered ETFs can provide tangible benefits to their portfolios in previously unconsidered ways. One example is by complementing an existing active manager by adding a short duration ETF to reduce overall duration in the portfolio, or to place a tactical position in emerging markets.

Thirdly, regarding the widespread adoption of ETFs, the latest figures from ETFGI show investors from across the world pouring $197.3bn (£153.37bn) into ETFs during the first three months of this year alone. Again there has been an increase in the ETFs available.

As a result, investors are now able to build broadly diversified, global fixed income portfolios more cost effectively and transparently. Both of which are investment characteristics that dominate investors’ list of priorities in a post-financial crisis world.

So what are the potential advantages of passive fixed income over active?

The “active versus passive” debate has long been a contentious and polarising topic for investors. 

The debate intensifies when it comes to fixed income, and there are fierce discussions over market segments with a traditional active manager bias, such as emerging market debt and convertible bonds.

My view is that investors should consider both approaches. For those who dismiss ETFs except for standard equity exposures, there is evidence that a passive approach to fixed income may offer a more consistent and predictable source of performance. This also holds in some less efficient markets, such as high yield and emerging market debt, where the ability of active approaches to consistently outperform their benchmark has come under question. 

For example, according to Morningstar, over the past five years, 90 per cent of active managers in the emerging market local currency sector have underperformed.

Another consideration is that active managers often allocate fixed income portfolios to non-benchmark sectors. This can make risk management more challenging. For many fixed income investors, consistent and predictable returns are primary objectives. 

The ultimate proof of fixed income ETFs’ credibility is that many active managers now include them within their own portfolios.