This is a sponsored article from State Street Global Advisors.
Global investors are increasing their exposure to Asian fixed income which has become more liquid, more mature, and offers attractive yields compared with many developed markets. To access the asset class, exchange-traded funds (ETFs) are fast becoming the avenue of choice, with a new survey by Greenwich Associates1 revealing that 24% of institutional investors already have a stake in Asian fixed income ETFs — the most popular passive fund option. A further 22% are considering adding them to their portfolios, giving these funds the highest potential growth rate among all investment vehicles.
Yet, common misconceptions about fixed income ETFs persist. Here, we look at the most pervasive misconceptions and separate the facts from fiction.
Misconception 1: Fixed income ETFs distort the market
Has the fixed income ETF market become so large that it can now distort the underlying bond market? Since the global financial crisis, demand for these funds has grown exponentially. In 2008, assets under management in fixed income ETFs represented US$48 billion, or around 1.9%, of the global fixed income fund industry, according to Morningstar. As of 30 June 2019, those assets exceeded US$1 trillion.
Given such robust growth, it comes as little surprise that allegations have surfaced claiming fixed income ETFs distort the bond market. However, the growth of ETFs has, in fact, kept pace with overall market growth. The total investable fixed income universe now stands at US$105 trillion, meaning fixed income ETFs only account for less than 1.5% of the market, and their influence on prices is therefore limited.
In addition, rather than altering the landscape, bond ETFs are an important source of additional liquidity in certain sectors. Some equity investors now use them to create fixed income beta exposure in both directions, for instance. This two-way flow in ETF shares also largely negates their impact on the market.
Misconception 2: Fixed income ETFs lack liquidity
Some investors remain cautious of fixed income ETFs owing to fears that volatile markets may strangle liquidity. While these concerns are understandable, they are misplaced. In reality, a fixed income ETF is at least as liquid as the underlying market it tracks.
The reason for this concerns the way in which fixed income ETFs are traded. Unlike its equity counterpart, the bond market is not centralised and instead operates through a dealer network with each offering a separate liquidity pool. It is therefore not only relatively opaque but also more operationally complex when it involves trading multiple securities in a single execution.
The fixed income ETF market, by contrast, has a two-tier liquidity system. In the primary market, ETF shares are created and redeemed, and in the secondary market, the shares are listed and traded on exchanges. Usually, investors buy or sell ETF securities through the secondary market but, if their buy or sell order is too large to trade on the exchange, the creation/redemption mechanism will be able to accommodate orders beyond the liquidity provided by the secondary market. Investors can therefore still trade in the primary and secondary market even if the underlying bonds become illiquid during, for example, periods of high volatility.
Misconception 3: Fixed income ETFs are unsuitable for investors seeking niche assets
Many investors used to believe an active approach was the best way to invest in niche markets, such as emerging market debt (EMD). That belief was based on assumptions such as that indexed exposure was too expensive to be effectively implemented in emerging markets. In addition, many investors were under the impression that active managers were necessary to identify and extract value in EMD and avoid weak market segments.
The reality is different. EMD now offers much greater liquidity and diversity, and the majority of active managers fail to outperform their benchmarks over the longer term.
We analysed active managers in the Morningstar database which tracks the JPM GBI-EM Global Diversified Index (GBI-EM) for the 2013-2018 period. The data shows a majority of active managers have failed to outperform the index. Indeed, their best year was 2017 when 60% of active managers underperformed, while in 2018, 97% of active managers underperformed the index.
While active managers have struggled to consistently deliver excess returns, indexed strategies have evolved and now utilise sophisticated techniques capable of delivering cost-efficient benchmark returns.
Reality: Fixed income ETFs offer investors greater diversification and liquidity at lower costs
The rising popularity of fixed income ETFs will not come as a surprise to investors who have completed due diligence on their myriad benefits. The ability of ETFs to enhance both portfolio liquidity and diversity combined with their lower cost structure make them highly attractive to a broad spectrum of market participants.
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1 State Street Global Advisors commissioned Greenwich Associates to conduct a global study of 151 institutional investors and 36 intermediary distributors from Asia Pacific, Europe and the United States between October 2018 and March 2019.
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This is a sponsored article from State Street Global Advisors.