A growing band of wealth managers are using exchange-traded funds (ETFs) to manage the duration of their bond exposure.
‘We have seen wealth managers’ use of fixed income ETFs changing markedly in the past 12 months,’ said Claire Perryman, head of SPDR ETFs in the UK for State Street Global Advisors.
‘Previously, ETFs were simply used to fill a gap where an active manager could not be found. More recently, however, we are seeing a trend towards combining active strategies with passive ETFs, for example to blend duration in a portfolio by using a complementary shorter duration ETF.’
Bryon Lake, head of international ETFs at JP Morgan Asset Management, believes fixed income ETFs will prove to be one of the fastest growing areas of the market.
‘At present, they’re a much smaller component of the market versus equity ETFs, which is largely down to the less mature nature of fixed income ETFs,’ he said.
Nine out of 10 (94%) UK financial advisers, wealth managers and private bankers use equity index products, while 60% use them for bond exposure, according to a survey of more than 130 investors by KPMG. Some 39% of index product users plan to increase their allocation in the next two years.
Wealth managers often use fixed income indexing products to access multiple exposures with a range of durations rather than having to buy a basket of individual bonds. ‘They recognise the potential diversification benefits of ETFs,’ said Perryman.
She also highlights the role of ETFs in difficult-to-access markets, such as emerging market debt or convertible bonds.
7IM buys high grade bonds, like UK gilts and US treasuries direct in the market or from the government, but tends to use ETFs in slightly less well trod areas like high yield and emerging market bonds.
Investors are also commonly using index tracking funds in areas of bond markets where they believe it is more challenging to generate alpha, such as short duration and inflation-linked bonds, according to the KMPG survey, which was commissioned by BlackRock.
Charles Stanley points to greater demand for shorter duration products amid concerns about rising interest rates. ‘Narrow bid/offer trading spreads in fixed income ETFs have made it easier for investors to access this type of bonds via ETF products,’ said senior analyst Lynn Hutchinson.
However, while ETFs give investors access to cheap diversification, this does come at as a price.
‘The nature of fixed income ETFs mean there is significant exposure to heavily indebted companies whose debt will represent a significant component of the index compared to a similar, but more cautiously managed firm,’ said Edward Park, an investment director at Brooks Macdonald, which tends to use ETFs only to make tactical asset allocation adjustments or re-invest proceeds while seeking a longer-term alternative.
For Kames Capital, this is a ‘highly illogical’ way of managing a credit fund, as it raises the risk profile without increasing the reward.
Adrian Hull, its co-head of fixed income, said: ‘We are seeing a rise in popularity of fixed income ETFs, but we believe the true nature of these is not completely clear and the myth that they are an inexpensive way to buy the market needs to be exploded.
‘What may come as a surprise to many investors is that a lot of these trackers do not even track the market; they track a subset of the market which is an easier benchmark.’
For example, the iShares $ High Yield ETF sets its benchmark as the iBoxx $ Liquid High Yield index, which is a subset of around 1,000 bonds, compared to 2,000 for the broader market that active managers measure themselves against.
‘It’s extremely difficult to replicate a bond index,’ said Alex Moore, a research analyst at Rathbones, which does not use fixed income ETFs. ‘Frequent bond issuance and redemptions means tracking the market without incurring high turnover costs is challenging.’
Many fixed income ETF investors also bear the currency risk from the index they track, which heightens their volatility.
Investors surveyed by KPMG point to demand for more innovative ways to weight fixed income index products.
While they are likely to continue to want cheap beta exposure to broader fixed income benchmarks, such as single currency investment grade credit, they are also now seeking smart beta or even active ETF solutions for more specialist areas of the market, according to Paul Syms, fixed income product specialist at Invesco PowerShares.
‘Smart beta may be less prominent in fixed income than in equity markets, but they strive for the same goal – creating an index with superior qualities to a broad market-cap-weighted benchmark to enhance returns, lower volatility or limit exposure to certain factors that may be considered undesirable.’
Early smart beta benchmarks sought alternative weightings to market capitalisation, such as using GDP weights for sovereign bonds or capping the maximum issuer weight in credit indices. More recently, however, even more innovative solutions such as time-weighted benchmarks designed to capture specific opportunities have been designed.
‘It feels like this is just the beginning of the journey for employing a smart passive approach to fixed income,’ added Syms.