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Supplements » ETFs Report 2012

FIXED INCOME: A case of US and them

Waving flagThe number of fixed income exchange-traded funds has grown, helped by investors seeking lower risk investments and diversification away from active funds. Muriel Oatham asks whether products are really new and innovative if providers are using ideas from America.

Fixed income has become a well-established exchange-traded fund (ETF) sector, accounting for nearly a third of net inflows this year. As assets have grown, so have the number and variety of products.  

Deborah Fuhr, a partner at research and consultancy firm ETFGI, says the fixed income ETF market has emerged.

“Eleven years ago, all ETFs were on equity benchmarks, and their users tended to be equity or multi-asset investors. But fixed income specialists have begun to embrace ETFs.

“The products evolved in a similar way to their equity counterparts: starting with big, well-known benchmarks and becoming more specialist.

“Now, we have country-specific products. We have corporate bond products which remove financials.

“We will not see fixed income products reach the same level of granularity as the equity market. But providers are adjusting to the reality of investing today.”

Manooj Mistry, UK head at db-xtrackers, agrees. “There is not as much diversification as in equity products, but there is still a reasonable choice for investors.”

He says the market has evolved from simply offering sovereign bonds on the main government indices.

“Fixed income ETFs now include direct investment, credit default swaps, short-term leveraged products, covered bonds, inflation-linked bonds, emerging markets and simple money market cash ETFs.”

Mistry says the development of individual markets supports ETF growth.

“As the underlying market becomes more tradeable, with improved transparency and liquidity, it becomes easier to link an ETF to it. So index providers and product providers can develop products accordingly.”

Claus Hein, head of institutional ETF sales at Lyxor, says demand for different types of fixed income ETFs is growing.

“Historically, there has been a lot of allocation into government bonds. But then corporate bond products expanded and now we are seeing demand for more specific exposure.

This year, the focus has been on high yield, and emerging market debt is very popular.”

Hein says demand has been driven by the financial markets. A lack of liquidity in the fixed income market means investors are turning to ETFs.

“As a structuring vehicle, ETFs offer efficient, liquid, cost-effective asset allocation to specific sectors. And they have the benefit of the ability to trade in a very illiquid market. Ability to trade is key.”

Tim Huver, ETF product manager at Vanguard, says the European ETF market has matured in terms of product offerings. “Adoption has accelerated since 2008, as investors have become increasingly risk averse or looked to build more diversification into portfolios.

“Investing in individual bonds can be expensive and impractical for an investor.  

“Fixed income ETFs can provide access to a greater portion of the fixed income market at a very low cost. And the intra-day trading flexibility of ETFs provides greater ease of access.”

Hein says the market is attracting new investors. “Many different clients are now using fixed income ETFs. For example, multi-managers who had previously used equity ETFs but not fixed income are now expanding their investment portfolios.”

“The way people are using ETFs is changing,” says Fuhr. “Many investors are looking for income, so high yield and corporate bond products have generated interest.

“But what is really driving [this market growth] is the growth of the multi-asset class: investors building an entire portfolio via ETFs.”  

She says this development, already significant in the US, will continue throughout Europe. “In the UK, post-retail distribution review, financial advisors will move from selling products to offering advice and implementation.

“And when advisers look at strategies such as risk profiling, fixed income products begin to play a more significant role.”

Mistry agrees that the trend away from stock or bond picking to asset allocation, and the increase in multi-asset portfolios and multi-manager funds, support ETF growth. “There is an emergence of managers using passive products in the multi-manager space.

“And institutional investors, such as pension funds, are moving towards a greater fixed income focus.”

Both new and existing clients are influencing the development of new products, which has been rapid. Providers say they are launching products in direct response to investor demand.

“At the beginning of 2012, we saw growing interest in products linked to eurozone periphery countries,” says Mistry. “Four months ago we launched a suite of products focused on Italian government bonds.

The short-duration products (one year or less) have been very popular.

“Investors get a high yield but you also have to take account of the implicit support of the ECB guarantee on these bonds. The return is between 2% and 2.25%: much higher than European money market rates.

“We have also seen interest in our High Yield Plus products which are focused on countries in the eurozone with a strong yield, such as Spain and Italy.”

Hein agrees that there is great opportunity for diversification within the government bond sector, where Lyxor has some 20 products. “In October, we launched two new short-term maturity products: one, two and three-year French and Italian bonds.

“Clients are saying they want to move away from broader European investment into specific countries, and also to be able to focus on specific maturities.”

Fixed income tableFuhr says this is a wider market trend. “Funds are adopting different strategies in terms of local markets, so we are finding that providers are trying to become more local or regional rather
than European.”

Mistry says products are becoming more sophisticated. “In June, we launched a family of ETFs linked to US credit. These offer exposure to pure credit through credit default swaps (CDS) exposure via the North American CDX indices.”

“Five years ago we launched a similar product in Europe using CDS via the iTraxx index. It has been a successful tactical investment tool alongside corporate bond exposure.”

While Fuhr agrees the market is expanding, she says there is little real innovation. Instead, providers are copying products from more advanced markets.

“Europe has tended to lag behind Canada and the US [in development of fixed income ETFs]. So are products really new and innovative if providers are using ideas from the US?”

She says the US will continue to influence Europe. “In the US, active ETFs are starting to take off. Pimco’s active products are gaining significant assets.”

But both providers and commentators deny that a proliferation of new products will lead to market fragmentation. They say opportunities for expansion remain. “In today’s market, fixed income ETFs are continuing to see significant growth and trading volumes, which supports opportunities to expand,” says Hein.  

He says large providers do not have an inherent advantage. “Overall trackability and tradeabiliy is only as liquid as the market itself. We have had instances where clients have requested an ETF offering exposure to a particular market index or segment but the market was not liquid or accessible enough to deliver it. There can be demand that cannot always be met.”

Mistry says the market is not yet saturated.

“There is always scope for new products if they are the right products and deliver the types of exposures investors demand.”

©2012 funds europe