ETFs - fixing exposure

Paul Burgin discovers strong appetite for fixed income products despite mixed performance

Across the investment world, fixed income was big news last year. Income hungry investors pulled back from equities and piled into sovereign, corporate bond and emerging market debt.

America’s Investment Company Institute says equity mutual fund outflows of $30bn were dwarfed by inflows of $242bn into taxable bond funds in the first 11 months of 2010.

European flows paint a similar picture. EFAMA, the association for the European investment management industry, reports bond Ucits funds were the most popular asset class in Q3, with net sales of €37bn. Britain’s Investment Management Association says bond sectors topped retail sales in five months last year.

Nevertheless, Lipper Feri warns of a ‘bond bombshell’ as Europeans pulled out of bond funds in December, marking the first net outflows for 21 months.

End of year jitters were likely caused by expectations that interest rates will rise. Worries about the euro and EU periphery nations has heightened fears of defaults or haircuts by beleaguered European nations and banks.

Flows to fixed income ETFs also dipped in December, according to BlackRock’s global research and implementation strategy team. The global annual net inflow was $37.7bn, also down on the previous year. But investors remained keen on European-listed products, primarily government index trackers. In Europe, around 20% of total ETF assets under management (AUM) is in fixed income, well above the global average.

According to Morningstar figures, there are now eight US-listed income ETF products with assets of over $5bn. The iShares TIPS Bond tracker is the largest. Vanguard Total Bond Market and State Street SPDR Barclays Capital High Yield Bond are also among those funds with the most assets.

The European perspective

The European market is catching up with the US. iShares Euro Corporate Bond and German Government Bond trackers are the largest. Two Lyxor products tracking short and medium EuroMTS hold around €1bn each - testament to the domestic investors’ love of money market and sovereign asset classes.

Fast growing developing markets offered the best returns last year, as they raised interest rates to stave off inflation, while currency also played its part. Morningstar figures confirm that products tracking commodity producing nations were best for sterling investors. Returns in certain Canadian and South African products were above 20%.

Conversely, European returns suffered. Many sovereign, high yield and investment grade corporate indices fell. The ComStage ETF iBoxx Eur Liquid Sovereigns Diversified long duration product fared worse, down almost 9%.

José Garcia-Zarate, ETF analyst at Morningstar, thinks money market ETFs also performed badly. They did well when interbank lending froze over but returns have dropped ever since. He says: “Money market ETF assets fell because yields dropped sharply. In Europe, they performed pretty badly and returns were close to zero.”

Despite mixed results, providers say interest in fixed income will likely stay strong this year. Blanca Koenig, fixed income strategist at iShares, says: “We have had massive inflows into short term government bonds, particularly UK, German and US. There have been heavy flows into corporate bonds, but outflows in medium and long term government bonds.”

Koenig surmises that investors have been using fixed income ETFs for technical positioning. They are actively trading to lower duration or tip portfolios towards corporate bonds.

The iShares Markit iBoxx Euro High Yield Bond product launched in September is already one of Europe’s top ten most traded fixed income products. Koenig says it attracted over €400m in four months. “We were positively surprised by the speed of the inflows. There is a lot of demand still out there.”

Seeking higher yield

Investors are keen on emerging market debt with its attractive higher yields and strong thematic play on growth and globalisation. So far iShares has concentrated largely on the sovereign market, with products such as the JPMorgan $ Emerging Markets Bond fund.

Emerging market corporates would be a useful addition to the range but are unlikely to appear soon in the iShares line up. Koenig says index replication is the main barrier to new developments. Emerging markets are generally far less liquid than developed ones. Replication of indices must be matched against liquidity.

To get around the issue, iShares and others have developed sampling methods. Rather than replicate an index fully, providers ignore the most illiquid stocks and up the weightings of others to compensate.

However, that gives rise to several concerns. Total expense ratios (TERs) and spreads on less liquid indices such as high yield and emerging market benchmarks tend to be wider, a reflection of their access and liquidity constraints. TERs hover around the 40 to 50 basis point mark, compared with 10 to 20 basis points for developed world government trackers.

Sampling naturally evokes fears over tracking error. Sterling, euro, dollar and most global sovereigns pose no problem but other sub-classes are more tricky. To overcome this, db-x trackers looked at credit default swap (CDS) indices for corporates, with the view that they are tradable, liquid and transparent. Manooj Mistry, head of db x-trackers in the UK, says: “The key difference is that they have no duration risk, so you get pure bond exposure. We can also offer more products, splitting financials from non-financials for example.”

Db x-trackers now offers 60 different fixed income ETFs, from Eonia money market funds to specialised corporate and sovereign products. Its high yield eurozone ETFs include weaker nations such as Portugal and Spain. More cautious investors can opt for an AAA-eurozone product that covers Europe’s strong nations such as France, Germany and the Netherlands.

New indices offer more opportunities to innovate, says Michael John Lytle, managing director of Source. The firm has just launched two new products with Pimco, the world’s largest fixed income fund manager, and both ETFs are listed on the Deutsche Boerse. The firms’ Euro Enhanced ETF is an actively managed fund investing in eurozone government and corporate bonds, as well as other asset-backed securities. The fund seeks to outperform the money market, taking the Eonia – the overnight interest rate calculated on an average of all unsecured interbank lending – as a benchmark.

The second product also focuses on sovereign debt. The European Advantage ETF uses an index based on GDP rather than market capitalisations of its constituents. In that way, Lytle says investors get more exposure to quality issuers who can service their debt rather than countries that have simply had to borrow larger amounts.