Fiona Rintoul looks at why bonds may make more sense in an ETF wrapper than equities do.
Fixed income exchange-traded funds (ETFs) have been the illegitimate child of the ETF universe. Less attention. Less money. Less love. While fixed income assets globally vastly outweigh equity assets, it is the other way around in the ETF universe, with fixed income ETFs accounting for just 22% of total assets under management (AuM) in ETFs in Europe. Could this be about to change?
“I personally think ETFs make more sense on the fixed income side than on the equity side,” says Andreas Zingg, head of ETF distribution Europe at Vanguard Asset Management, and he is not alone. According to a recent EDHEC European ETF and Smart Beta and Factor Investing Survey, the percentage of investors using ETFs for governments and corporate bonds has risen from 13% and 6%, respectively, in 2006 to 62% and 66% in 2018.
The global financial crisis helped to make the case for fixed income ETFs. Zingg points out that the cost of trading fixed income has increased since 2008, and there is less liquidity in the market.
“ETFs allow investors to trade below the cost they would face in the underlying market,” he says.
There is also a transparency argument for fixed income ETFs. “As the fixed income markets tend to be less transparent and accessible to investors than equities, ETFs offered an interesting way to access this asset class by allowing them to buy a diversified basket of bonds in one go,” says Caroline Baron, regional head of ETF sales at Franklin Templeton.
ETFs democratised the use of bonds and offered transparency, Baron claims. Meanwhile, institutional clients have found advantages in using fixed income ETFs, particularly in the wake of the financial crisis when inventory has been harder to source.
Spain vs Germany
It’s partly a question of cost. The cheap access that ETFs afford to a basket of securities is even more valuable in the less transparent fixed income sector than in the equity sector. Fees for fixed income ETFs are typically higher than for equity ETFs, but promoters feel this is justified, as the cheaper-is-better equation doesn’t exactly apply to fixed income products.
“On the fixed income side, first there are so many benchmarks,” says Nicolas Fragneau, head of ETF product specialists at Amundi. “On top of that, you add a layer of customisation to those indices.” He cites the example of euro government ETFs. A few years back, this was split into core euro govvies and peripheral euro govvies, so that investors could, for example, play Italy and Spain versus Germany and France.
“The fact that we offer that kind of solution on top, to me means it makes sense that we charge a little bit more than we do on the equity side,” he says. “It’s not just about offering the same thing as everybody else; it’s about offering one special index with one special covering that we think is more interesting in the present environment.”
Other fixed income ETFs that Amundi feels fit the current mood music include floating-rate notes ETFs and triple-B corporate ETFs. This focus on helping investors to navigate the actually existing market environment means there is more turnover in ETFs on the fixed income side than on the equity side, where the decision to be in or out is more of a binary choice. “When you’re positive on one particular region or type of bond, there are many ways to play and to fine-tune that exposure,” says Fragneau. “Investors are going to choose different fine-tunings depending on their views. There will be more rotation among those fine-tunings and so it’s more diversified than it is on the equity side.”
And diversification is on the increase, with new solutions coming to the market. Some are the brainchildren of smaller providers that see an unexploited niche. Such is the case with the first euro-based ETF on a European bank ‘CoCo’ - contingent convertible - bond index, launched in July by China Post Global.
“This was a product that we felt the market needed,” says Danny Dolan, managing director of China Post Global (UK). “We’ve seen quite a lot of investor demand. Often they were in considerably more expensive actively managed funds where the performance was less than the iBoxx index that we’ve licensed.”
Other areas of development include smart beta, factor investing and active fixed income ETFs. In June this year, Franklin Templeton launched two active fixed income ETFs. According to Baron, these were designed to address some of the concerns that investors have about traditional fixed income ETFs, including the prevalence of debt-issuance weighted indices.
“That way of constructing a benchmark may appear counterintuitive and it might carry risks that investors will need to assess,” Baron says. “In a world where we expect interest rates to rise, those debt-weighted benchmarks will not have the ability to manage the duration risk, for example, so investors will have to closely monitor their portfolio and to reallocate between ETFs to make sure they are rightly positioned.”
In some ways, then, Franklin Templeton’s active fixed income ETFs are designed to circumvent the kind of fine-tuning Fragneau describes. They have an active manager who picks bonds using a bottom-up and top-down approach and takes account of factors such as interest rates and issuer credit quality. This makes them pretty similar to bond funds. The costs can be similar too, though Baron says they are diced up a little differently. What, then, is the point?
“From our portfolio manager’s point of view, ETFs can be more efficient to manage versus traditional mutual funds because of the creation and redemption mechanism allowing more flexibility to manage the portfolio,” says Baron.
Other advantages of the ETF structure include daily transparency and intraday liquidity. The non-mutualisation of costs is another potential plus.
“When you have many investors entering and exiting the ETF, the costs of that activity will be borne by the investors buying and selling the ETFs, not by the existing shareholders of the ETFs, meaning that the performance of the ETF will not be impacted,” says Baron.
Active fixed income
Active ETFs remain a minority pursuit. But Baron makes the interesting point that they thrive more on the fixed income side – where “traditional indices may not be the answer to manage the current market conditions and will have some inefficiencies and risks” – than on the equity side, with 75% of Europe’s $10 billion of active ETF assets attributable to fixed income products.
“We believe that the active ETF category will grow substantially over time, but it will require mentalities to change,” Baron says. “An ETF is not always a passive vehicle. It is a wrapper that allows investors to access the world of equities, fixed income or commodities either by tracking a specific index or by trying to beat a benchmark.”
When it comes to smart beta and factor investing, the ratio is the other way around: equity ETFs predominate. However, the recent EDHEC report found “significant interest” in fixed income smart beta solutions. Lionel Martellini, director at the EDHEC-Risk Institute, believes the fixed income sector is the new frontier in the development of meaningful smart factor investment solutions in the fixed income space, but that more research is needed. One reason is that the first generation of smart beta in fixed income markets was based on a direct transfer of fundamental indexing methodologies originally developed for equities.
“The key problem in this approach is that it is unclear why some backward-looking trailing average of some arbitrarily selected variables should contain more useful information than, say, bond ratings, which for all their flaws are based on a much richer information set,” says Martellini.
A more meaningful approach, in his view, is to construct investable proxies for rewarded risk fixed income factors such as interest rate and credit risk factors, but also liquidity risk factors, low-risk factors, carry factors, value factors and momentum factors, suitably extended to bond markets. But it ain’t easy.
“The calibration of factor investing strategies in bond markets poses a number of specific technical and implementation challenges,” he says.
Some providers, such as BlackRock, Robeco and AQR, have launched fixed income factor investing funds, but fee levels remain substantially higher than in the equity universe. Meanwhile, Martellini expects new research – for example, into how value can be added via a time-varying exposure to the traditional factors impacting bond returns – to lead to “the launch of innovative new forms of smart beta and factor investing lower-cost ETF products, especially in sovereign bond markets”.
For some, however, this is all whistling in the wind. At Vanguard, for example, they prefer to stick to a smaller range of products that offer broadly diversified exposure. “We don’t see a strong need for these alternative beta products,” says Zingg, who would rather see more price competition on broadly based fixed income ETFs. “You need to find a strategy that resonates with the majority of the market, otherwise a fund is not really the right vehicle.”
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