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The fixed income exchange-traded funds (ETFs) market has experienced rapid growth in recent years as more investors are now finding a role for them in their portfolios. We explore the drivers behind this expansion, the rationale for low-cost indexing in fixed income and the challenges investors face in selecting bond ETF providers.

Growing demand

The combination of collective investing and the trading flexibility of a single security are well known benefits of ETFs. Blending the diversification and professional management of mutual funds with the continuous pricing and liquidity of individual shares, ETF assets have burgeoned in recent years.

While ETFs are more commonly associated with equities and commodities, bonds are taking an increasing share of the action. The market share of European fixed income ETFs has steadily grown each year since 2010 and now stands at 22%, up from 14% in 2010 (all data sourced from ETFGI). In 2014, net new flows into fixed income ETFs nearly doubled year-on-year and 2017 was the best year ever for new flows into fixed income ETFs in Europe.

The obvious explanation for the rise in bond ETFs is demand from investors. With interest rates still at or near the historic lows reached following the global financial crisis, investors continue to grapple with bonds’ risk-dampening attributes and the search for higher-yielding assets. 

One trade, many bonds

These needs, coupled with the quantitative easing policies of major central banks since 2008, have meant the availability of some bonds has deteriorated considerably. This is particularly prevalent in areas such as corporate credit, high yield and emerging markets debt. As it has become more difficult to hold bonds directly, ETFs have stepped in to fill the gap. 

Investors seeking exposure in these areas can effectively add thousands of bonds to their portfolio in a single trade. Few investors – even professional asset managers – can achieve such well-diversified, broad exposure in such a cost-effective way as an ETF. 

Another advantage many investors are recognising is the ease of capital and income reinvestment. Compared with individual bonds, fixed income ETFs provide timelier reinvestment of principal and cash flows. 

Increasing supply

As demand has grown, the industry has responded. Almost 80 more fixed income ETFs are now available in Europe compared with the end of 2016. They cover a range of markets and indices. Interestingly, we’ve seen a significant rise in the number of corporate bond, EM debt and inflation-linked bond ETFs – all areas where it has been difficult for investors to access individual securities over the last few years. 

This accessibility is one of the keys to the success of fixed income ETFs, and ETFs in general. Another factor is their lower fees and expenses. Collective investing lowers costs and ETFs are generally lower cost than mutual funds. This makes them an attractive, cost-effective option in an industry in which margins are under pressure. 

Furthermore, research from Vanguard shows that by focusing on low-cost funds (both active and passive), the probability of outperforming higher-cost portfolios increases1. After all, every basis point an investor pays in fees is a basis point less in returns. And while we do not know what future returns will be, we do know what the costs are.  For most investors, the best chance of maximising net returns over the long term lies in minimising these costs. 

But it’s not just about maximising returns and minimising costs. Investors need to consider risk beyond the volatility of returns. They must be confident that their chosen investment funds provide adequate safeguards for client assets. 

Regulatory safeguards

Increasing awareness that ETFs share the same regulatory environment as mutual funds is allaying these concerns. The vast majority of European-domiciled ETFs are organised and regulated under the UCITS directive. While all investing involves risk, this framework provides various degrees of investor protection by ensuring underlying investments are liquid, portfolios are diversified and assets are ring-fenced and held by a custodian.  

Versatile portfolio tools

As the growing numbers of investors embracing fixed income ETFs are finding, they can be highly versatile portfolio tools. The ways that bond ETFs can be used by investors are many and varied, ranging from liquidity and transition management to rebalancing and overlay strategies.

But for many investors, bond ETFs will form the core building blocks of their fixed income allocation. These investors can use ETFs to help them gain fast, precise and cost-effective access to a broad variety of sub-asset classes within fixed income to build a strategic core bond portfolio. 

Indexing is a central function of fixed income ETFs, and the evolution of the market for bond ETFs has paralleled the growth of indexing more broadly within fixed income. Here, the case for passive investment is compelling.

The zero-sum game

Increasing numbers of investors are now discovering the potential of index funds that track fixed income indices. These bond index funds offer investors a number of advantages, including the consistent maintenance of portfolio risk characteristics, diversification and low cost.

The central concept underlying the case for index-fund investing is that of the zero-sum game. This theory states that each position that outperforms the market return is offset by a position that underperforms the market by the same amount. Presented graphically, all market participants’ asset-weighted returns form a bell curve around the market’s return, as can be seen in figure 1.

market participants asset weighted returns form a bell curve around the market’s returns

However, after costs are allowed for, investing becomes a negative-sum game. In other words, after accounting for costs, the aggregate performance of investors is less than zero sum, and as costs increase, the performance deficit becomes larger. This is demonstrated in figure 2.

Once merged and liquidated funds are considered, a clear majority of actively managed bond funds fail to outperform their benchmarks after fees. As figure 3 shows, negative excess returns tend to be more common than positive excess returns.

The impact of costs on bond fund returns is even more pronounced than for equity funds. Given that bonds have historically exhibited lower returns than shares, costs tend to be a more significant drag on performance, and therefore to exert an important influence on returns.

What’s more, as we expect lower returns in fixed income markets (as well as in equity markets) going forward compared with historical standards, the impact of fees on returns is likely to become even more significant.

Consistent risk characteristics

Beyond the cost benefits, bond index funds can provide investors with the ability to keep the risk makeup of their fixed income portfolio at a steady level.

Liquidations, both full and partial, are much easier from bond index funds than from more concentrated bond holdings as the consistent cash flows into and out of index funds enable the fund managers to make incremental purchases and liquidations. 

Bond index funds maintain more consistent risk characteristics, such as duration, over time because of these more regular, ongoing cash flows. 

Diversification benefits

Low-cost bond index funds also bring considerable diversification benefits, among issuers, credit qualities and term structures. Fixed income index funds can provide better protection against losses than more concentrated holdings owing to the broad universe of exposure they offer.

This diversification is particularly beneficial when it comes to default risk – that is, investors’ perception of an issuer’s willingness and ability to honour the terms of the obligation. This is a particular concern in the corporate bond market, where the dynamic nature of credit risk makes it essential to diversify issuer-specific risk.

This diversification also typically delivers higher risk-adjusted returns. Undiversified bond investors often try to hedge default risk by increasing their exposure to bonds of the highest credit quality. However, this approach sacrifices the potentially higher returns available from lower credit quality bonds.

The diversification offered by a bond index fund can incorporate higher-return opportunities further out on the credit quality spectrum, without the investor having to hold disproportionate exposures to higher-yielding issues.

Within government and supranational bonds in particular, index funds also provide diversification among a range of maturities. This is because they often have exposure to a number of different bonds across the term structure from the same issuer.

Expanding choice

In Europe alone, as of the end of June, there were around 350 fixed income ETFs with more than $180bn in assets (data sourced from Morningstar). This is up from around 270 fixed income ETFs with around $130bn in assets at the end of 2016.

Given the amount of choice between different products and providers, it is important that investors are in a position to make informed decisions about which ETF, and which ETF manager, is right for them.

Choose your benchmark wisely

A single fixed income ETF can give investors access to a portfolio of hundreds if not thousands of bonds, diversified by issuer, by credit quality and by term structure. But it is important to select a bond ETF that tracks a benchmark reflecting the investor’s true opportunity set. This can help investors ensure they are getting appropriate exposure that matches their risk appetite.

Good indices should reflect the actual investment universe available to active management, and therefore the way that asset managers actually invest.

This can be more of a challenge in fixed income, where the investment universe is much broader than is the case with equities. And yet despite this, the availability of some bond issues may be limited, as we already mentioned. This is why it is especially important for investors to choose a fixed income ETF with an index methodology that is clear, easy to access and simple to understand. 

For example, among US dollar-denominated corporate bond indices, the Bloomberg Barclays Global Aggregate Corporate USD Total Return index, which the Vanguard USD Corporate Bond UCITS ETF tracks, has more than 7,100 constituents. By contrast, the Markit iBoxx USD Liquid Investment Grade 150 Mid Price TCA total return index, which covers the same asset class, has only 150.

The index inclusion criteria drives the number of constituents. This criteria usually includes a minimum issuance size and a minimum maturity requirement. The constituents, in turn, drive the risk, return and yield characteristics of the indices, and more diversified indices tend to have lower duration risk but similar yields.

Investors should take care to select a strategy that is aligned with helping them achieve their investment objectives.

It is also a good idea to track an index with a proven track record, one that has demonstrated consistency not just in its construction but also in its exposure over time.

Scale and expertise

Building such a well-diversified bond portfolio requires an ETF provider to have sufficient scale and experience to enable it to assemble and manage large portfolios.

The scale of the provider is a key consideration for investors in fixed income ETFs when it comes to costs, too. As larger ETF managers typically place larger trades than smaller providers, they can secure lower execution costs than those available to smaller managers. This gives them access to narrower spreads on trades.

ETF providers with economies of scale typically have considerable bargaining power in the bond markets as they have access to a wide variety of dealers and counterparties. This improved access can lead to more favourable pricing.

Providers also need multiple authorised participants and market makers for their ETFs and an experienced capital markets team who have the expertise to place large trades, add new issues and reinvest income efficiently and effectively. 

The best ETF providers will have the experience and skill to develop and deliver the best products for investors. These providers will consistently be investing in the talent and technology to improve their products and will have a strong network of relationships within the ETF ecosystem.

Costs matter

The rise of fixed income ETFs shows no signs of abating, and low-cost bond index funds are set to be a key part of this growth.

In a world of low yields, investing costs matter a lot. This is especially true for bond markets, where in recent years yields have been below their historical averages and costs erode a larger share of returns than they have in the past.

Choosing a low-cost fixed income ETF in this environment makes sense. All else being equal, lower costs should translate into higher net returns and better performance.

Andreas Zingg is head of Vanguard’s ETF sales specialists in Europe