What to look for in a fixed income ETF
05 December 2018 | Portfolio construction
Commentary by Andreas Zingg, Vanguard head of ETF sales specialists for Europe.
A growing awareness of the benefits of fixed income exchange-traded funds (ETFs) has led to rapid expansion of the market in recent years.
As a result of this growth, investors are now faced with a much wider choice of bond ETFs and ETF providers.
Combining the diversification and professional management of mutual funds with the continuous pricing and liquidity of individual shares, ETF assets have burgeoned in recent years.
Market conditions have fuelled this demand, with interest rates still at low levels by historical standards.
For many types of investors, ETFs offer the most versatile and transparent route to access low-cost passive fixed income investments. And while there is already a wide variety of fixed income exposures available through ETFs, the range is growing by the month.
In Europe alone, as of the end of June, there were around 350 fixed income ETFs with more than $180 bn in assets (data sourced from Morningstar). This is up from around 270 fixed income ETFs with around $130 bn in assets at the end of 2016.
Figure 1: Growth of fixed income ETF assets
Given this broad choice, it is important for investors 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 investment universe available to all investors, both active and passive.
This can be a challenge in fixed income, where the universe is much broader than is the case with equities. And yet despite this, the availability of some bond issues may be limited. This is why it is especially important for investors to choose a fixed income ETF with an index methodology that is clear and easy to access.
The index inclusion criteria drive the number of constituents, and usually include a minimum issuance size and maturity requirement. The constituents, in turn, drive the risk, return and yield characteristics of the index, and more diversified indices tend to have lower duration risk than less diversified indices but similar yields.
Investors should 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 them 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. 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 can lead to more favourable pricing.
Providers also need multiple authorized 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.
The rise of fixed income ETFs shows no signs of abating.
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.
Investment risk information:
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.
Other important information:
This article is directed at professional investors and should not be distributed to, or relied upon by retail investors.
This article is designed for use by, and is directed only at persons resident in the UK.
It is for informational purposes only and is not a recommendation or solicitation to buy or sell investments.
The opinions expressed in this article are those of the author and may not be representative of Vanguard Asset Management, Limited.
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