In Focus: Megatrends  

Four reasons why bond ETFs underperform the index

4) Liquidity preference

According to Baines, ETFs are often used a tool by fast money investors or high frequency traders to add or reduce exposure to the high yield bond market.

But this often makes the ETFs the biggest buyers on up days and the biggest sellers on down days.

Therefore, the ETF tends to be buying on the offer side when bonds are expensive and selling at the bid side when bonds are cheap. This adds further to trading costs.

Baines added: "We can see this dynamic from looking at the discount and premium to net asset value. The ETF often fluctuates between -0.5 per cent and +0.5 per cent. This demand that the ETF has for liquidity comes at a cost from the rest of the market – in the form of lower returns."

Cost concerns or market quality?

Over the past decade, there has been a pronounced shift towards promoting passives, with exam curriculums seeming to favour a shift towards advisers using passives for most clients in a bid to drive down costs.

Even the FCA has repeatedly made the point that "Active fund management is necessarily more costly than passive fund management, and these costs can cause active funds to (on average) underperform the market."

But in a 2019 research paper on whether passive investing affects market efficiency and market effectiveness, the FCA said while choosing passive management might be "individually sensible", it could have an impact on the quality of the overall market.

The 16-page research note stated: "Each investor individually has an incentive to take market quality as given and opt for lower cost passively managed funds.

"If a sufficient proportion of investors do opt for passive management, then it is possible that these individually sensible choices may in aggregate lead to investor detriment due to their adverse impact on market quality and so on overall economic performance."

simoney.kyriakou@ft.com