As the ETF market moves towards more specialist products, Nina Röhrbein looks at fixed income, leveraged and style funds
Traditionally ETFs have been thought of as equity products. However, the first fixed income ETF was launched in Canada in November 2000, according to Morgan Stanley’s 2007 Global Industry Review on ETFs. Since then trading volumes of other ETF types have grown sharply. These new initiatives include inverse (short) and leverage ETFs, and value and growth ETFs, according to Deborah Fuhr, managing director for investment strategies at Morgan Stanley.
Fixed income ETFs currently only make up 7.5% - around $60bn (€38bn), in January 2008 - of the whole ETF market, according to iShares, the ETF arm of Barclays Global Investors (BGI).
“Because the fixed income ETF market is very much in its infancy, it still has a long way to grow to where it should be,” says Alex Claringbull, portfolio manager fixed income solutions at iShares. “We believe assets in fixed income ETFs will grow by over 200% to surpass $200bn over the next three years. Assets have already grown by 230% from $18bn in June 2005. So far this year we have witnessed particularly strong trading.”
Danièle Tohmé-Adet, (pictured right) co-head of BNP Paribas’ and AXA Investment Managers’ EasyETF platform, attributes this surge to a desire for diversification. “We have seen huge amounts being allocated to our fixed income ETFs because of this,” she says. “The first flight to fixed income came from the credit space. But then asset managers also started to invest again in some specific asset classes.”
iShares began offering fixed income ETFs in 2003. “A lot of investors in the UK, continental Europe and the Middle East already have an allocation to fixed income within their asset allocation or personal pension accounts, so there clearly is long-term demand for these types of ETFs,” says Claringbull.
“Fixed income ETFs are popular with both institutional and retail clients albeit for different reasons. Retail clients like them because they provide an easy way to access markets, while ETFs are important to institutions because by avoiding having to trade multiple lines of the underlying bonds they allow them to take asset allocation positions very quickly. We see demand for fixed income ETFs stemming from a broad investor spectrum such as wealth managers, private banks, corporate treasurers and small- to medium-sized pension funds.”
Claringbull believes that the amount of research and operational capacity required to buy, for example, diversified corporate bonds makes it difficult for investors to purchase them directly.
“An ETF does not stock pick the individual bonds,” he says. “However, as an index tracker it does offer diversification and takes away the need to have an operational platform or internal portfolio managers that trade them. On top of that, all the risk characteristics, exposures and durations of the ETF are transparent for the investor to see.”
Like traditional fixed income products, fixed income ETFs come in all shapes and sizes. Like equity ETFs, they provide exposure to a fixed income index and aim to deliver its returns in an open and transparent way, according to Claringbull.
“We have fixed income ETFs listed on various bourses around Europe that track indices covering government, credit, corporate and inflation bonds in the three main currencies of sterling, euros and US dollars,” he says. “We also recently launched a fund that tracks dollar-denominated emerging market bonds. That turned out to be our fastest seeded fixed income ETF to date. Emerging market ETFs have proved to be one of the most popular this year, only being topped by inflation bond ETFs that have performed very well compared with other bond asset classes. We have also seen good flows into short government bonds with a maturity of up to three years and a limited yield curve risk.”
“Following on from global equities, it was a logical move to create fixed income ETFs to cover sovereign debt,” says John Davies, (pictured left) director of market development at S&P Index Services, which is working on some products in the fixed income space. “More recently, we have seen investors advance into the credit ETF space as well. And that is why we believe investors will go into other niche fixed income areas in the future such as high-yield.”
Tim Mitchell, (pictured right) head of investing, institutions, at Invesco, agrees. “The high-yield market barely existed 10 years ago but it is large right now,” he says. “Many corporates use the high-yield market to raise assets, so it makes sense for more products to develop that allow investors to get access to high yield. Continental European markets are especially keen to develop fixed income products because by nature their portfolios tend to be more oriented towards fixed income. However, UK investors tend to use bonds more as a safe-haven or income enhancement and mainly invest in them when equity markets are doing poorly.”
“For us, it has been the Euro OverNight Index Average (Eonia) ETF that has been particularly successful, raising over €1.5bn since its launch last November,” says Dan Draper, (pictured left) global head of ETFs at Lyxor Asset Management, a Société Générale subsidiary. “At the moment we see the most ETF fixed income interest in cash and short-dated government ETFs with some clients just starting to nibble on our euro inflation-linked ETF as a hedge against the potential inflation that may follow the recent loosening of global monetary policy conditions. Fixed income indexing is a relatively new area compared to equity indexing and, as fixed income trading is predominantly an over-the-counter [OTC] market, fixed income ETFs are not as well known as equity ETFs.”
An Eonia ETF, which has raised €2.7bn since its launch in May 2007, also proved successful for Deutsche Bank, according to Thorsten Michalik, (pictured right) head of db x-trackers - Deutsche Bank ETFs. “As a traditional fixed income provider we quickly started to offer fixed income ETFs although we only started our ETF business in January 2007,” Michalik says. “For us, the ETF is just another wrapper that offers access to fixed income products. But the advantage of a fixed income ETF is that it has a set duration due to the constant duration of indices.”
Draper adds: “Fixed income ETFs have profited from the credit crunch because with alpha so hard to find in fixed income, investors increasingly look towards passive solutions such as ETFs. In particular the Fed’s rate cuts and a general flight to quality have prompted people to move out of active bond funds and buy passive since last August.”
In the US, dollar- and inflation-linked ETFs have drawn a lot of investor attention over recent months, according to Jim Ross, (pictured left) senior managing director at State Street in the US (see p 12). “Over the last few months we have launched an international treasury and an international TIPS [treasury inflation-protected securities] ETF, in other words a treasury and inflation-protected securities fund, which is fully invested outside the US,” he says.
“And the credit crunch has been reflected in the interest in our new products such as US Treasury bills. Over the last six months our focus has been on fixed income ETFs, in particular government and municipal bonds, which are tax-free in the US. And we expect to see even more focus on international fixed income ETFs in the next few months as investors continue to look for investment areas where they feel some degree of security and comfort.”
But education in non-equity ETF asset classes such as fixed income is an important factor in building the growth in fixed income ETFs. “To reflect the investment world outside ETFs, the fixed income share of the ETF market should be much higher,” says Claringbull. “And, therefore, more investor education is needed.”
While some like Claringbull say the costs for ETFs are at the level the market is prepared to pay, Tohmé-Adet says investors with their own bond desks would not be interested in paying extra for fixed income ETFs.
Ross agrees, saying that pension funds would only make use of fixed income ETFs if they did not have a cost advantage in doing it directly. “However, smaller pension funds that struggle with back office requirements benefit from the transparency and liquidity of fixed income ETFs,” he concedes.
And in general market participants anticipate strong growth. “We expect growth rates for fixed income ETFs to be higher than for equities over the next few years,” says Michalik. “Nevertheless, demand will also continue for equity ETFs and the actual invested sums will be higher in those.”
Inverse - also known as short or bear ETFs - provide reverse index performance once or twice a day by betting on index declines, while leveraged ETFs are designed to provide up to 200% daily upside performance by amplifying the rises and falls of its benchmarks, according to the Morgan Stanley 2007 Global Industry Review on ETFs. These ETFs - whose total expense ratios range from 0.40% to 1.60% - can be used to magnify returns, hedge portfolios and manage risk without the need for a margin account or margin calls, says the review.
Société Générale Asset Management (SGAM) admits a drawback with leveraged ETFs is that, in the event of a sharp fall in the index of 50% in one day, its net asset value would drop to zero, which could result in delisting from the ETFs involved. The risk for inverse ETFs is if the index increases, the ETF’s value would decrease according to its index exposure.
“Until ETFs changed the market, investors could only go long on certain indices due to the lack of futures,” says Michalik. “With ETFs investors can now go long on indices they had not had access to so far and with the introduction of short ETFs also short. There are only approximately 100 futures globally but over 1,200 ETFs.”
SGAM is a specialist player in the ETF space, focussing on ETFs that deliver a particular risk profile such as inverse and leverage or with capital protection. “We have seen a lot of appetite for ETFs with a bear exposure - and for ETFs with leverage exposure to a lesser extent - and have witnessed exponential growth in this area, particularly since October 2007,” says François Millet, head of SGAM AI ETF.
SGAM’s business took off around the same time and saw its assets under management increase by 90% over the last 12 months. Most of its clients are in France, Italy, Benelux and Switzerland.
“Inverse and leverage ETFs are a solution for investors who either cannot use derivatives or do not have the back office infrastructure to respond to daily margin calls,” says Millet. “They are also more convenient to use for big investors such as funds of funds that cannot use tradable instruments or direct futures. Alternative funds of funds invest in our bear ETF because the equity beta of their portfolios is too high and it is a way for them to hedge. If investors want to build a short position they do not have many options. Borrowing stocks in order to obtain a short position has become more difficult in the current investment climate.”
Investors in short ETFs are diverse and include private banks and family offices, according to Michalik. But despite interest from these areas, investors in inverse and leverage ETFs are still predominantly institutional, says Davies.
“Leverage equity ETFs are popular with bullish investors who have a strong view on the market,” says Draper. “It gives them the ability to express their investment view two times the return of the index, but it is very important to remember that this leverage can also work against them to the same degree.
Leverage ETFs also lack a track record that would fit into most strategic asset allocation models. It is an open question as to whether it is better to include the leverage inside the ETF or for the investor to seek leverage elsewhere in the portfolio. It all really depends on the investor’s unique set of circumstances. That is why the typical leveraged ETF investors are speculative day traders who try to generate alpha through market-timing and securities selection, rather than strategic asset allocators like pension funds.”
“The demand for short ETFs generally stems from investors who want to participate when the market falls for a few weeks,” says Michalik.
“Market discussions surrounding the ability to go long and short on certain indices have been underway for a while, so the current demand is unrelated to the credit crunch and its resulting volatility,” says Davies. “We have recently worked together with Deutsche Bank and SGAM but the majority of other ETF providers are also very interested in developing inverse and leverage ETFs. So I expect increasing demand for these types of strategy. Inverse and leverage ETFs give investors the option to take a view on a particular market without actually moving away from it. They enable them to efficiently manage the exposure to markets, in particular those that lack derivatives.”
Draper says the credit crisis has highlighted some of the attractive features of ETFs, such as their ability to be used in inverse and leverage trade, and helped their business.
Lyxor currently offers leveraged ETFs on the DAX and the Dow Jones EuroSTOXX50 and is also considering the opportunities for inverse ETFs.
SGAM’s leveraged ETFs are built via the constant proportion portfolio insurance (CPPI) process and have a capital protection of 50% on some indices. “The concept of our leveraged and bear ETFs is that they are not only tracking an index but also form a reference capital portfolio composed of one index and another asset class like money market funds,” says Millet. “For the future we will continue to look at ETFs combining several asset classes at the same time and playing around long or short exposure concepts.”
“What is important to keep in mind is that short ETFs are not asset gatherers, in other words providers can never make a lot of money on them because - as investors are still bullish over the long-term - they only use them over the short term,” says Michalik. “Nevertheless, we have already accumulated more than €500m in our range of short ETFs.”
But while many providers - such as ETF Securities that listed 33 short and 33 leverage exchange-traded commodities in March - may appear keen to jump on the inverse and leverage bandwagon, others are still hesitant.
“We do not yet have inverse or leverage ETFs,” says Tohmé-Adet. “We have so far not wanted to get involved in structured ETFs with leverage as we feel their exposure is not clear and transparent enough to the customer as of now.”