Actively manage duration, credit and inflation risks with ETFs
The universe of fixed income exchange-traded funds (ETFs) has grown rapidly in recent years, allowing investors to access more esoteric and specific segments of the bond market.
As ETF issuers broaden the range of strategies offered, investors have started to significantly increase their exposure to fixed income ETFs. Highlighting this, bond ETFs have recorded inflows of 95.4 billion euros since the start of 2019, bringing total assets under management (AUM) to 271 billion euros, as of the end of March, according to Morningstar data.
However, the potential for further development is enormous. The International Capital Market Association (ICMA) estimated the global bond market to be around $ 128.3 billion as of August last year, compared to around $ 68.7 billion for the equity market. This highlights the potential for ETF issuers to focus on very specific segments of the market in order to empower professional investors in building their portfolios.
As Andrew Limberis, Investment Manager at Omba Advisory & Investments, said: “The main advantages of fixed income ETFs are liquidity, diversification and access.
“Liquidity is a key advantage for investors who do not have the resources to research and trade at such competitive spreads. This is largely made possible by the scale and sophistication of the ETF ecosystem as well as the useful dynamics of trading in the secondary market of the ETF itself.
“Meanwhile, the ability to quickly reduce the idiosyncratic risk that one can have by owning a few selected names is a major advantage and in the blink of an eye, investors can easily access many types of bonds, from China to the United States via the emerging local currency. markets, CoCo bonds and inflation intermediaries. “
Accordingly, this article will examine how investors can actively manage their credit, inflation and duration risk with ETFs, while providing an in-depth analysis of how each sub-fund has developed over the past few years and what more. issuers can do to enable efficient portfolio management.
The most advanced of the three compartments in terms of product development, bond ETFs – particularly in the government bond space and particularly in the US Treasury bill market – allow investors to target specific objectives that may be useful when looking to increase or decrease the duration of the overall portfolio.
For example, if an investor finds that they are significantly overweight their benchmark from a duration perspective because of the bets taken by their active managers, ETFs are a useful way to fine tune the portfolio to ensure they are are not overexposed to rising interest rates.
While there aren’t as many bonds in the gilt space, the depth of the US Treasury bill market has allowed ETF issuers to launch very specific strategies in recent years, which led to more precise portfolio management.
Highlighting this, Europe’s largest ETF issuer, BlackRock, offers US Treasury ETFs with a maturity of 0-1 year, 1-3 year, 3-7 year, 7-10 year, and 20 years and over, each strategy charging less than 10 basis points. Other ETF issuers have followed suit and options for European investors have increased significantly.
According to Jordan Sriharan, Head of MPS and Liabilities at Canaccord Genuity Wealth Management, the government bond space, in particular, has been an area where ETFs have been dominant due to the inability of active managers to outperform. the index.
“With credit, it’s a big universe, so active managers can generate alpha, but there is no price discovery in the government bond space,” Sriharan continued. “This is why we generally use ETFs for our exposure to government bonds.”
Credit is the area of the bond market where ETF issuers have the most potential to significantly improve their offering to investors, especially in Europe. The reason it has the most potential is simply due to the sheer size of the corporate bond market.
ETF issuers broadly split the market into quality and high yield investments, the largest being the EUR 10 billion iShares Core € Corp Bond UCITS ETF (IEAC) and the iShares € High Yield Corp Bond UCITS, respectively. EUR 5.7 billion ETF (IHYG).
However, issuers have yet to integrate more specific segments of the market, such as only “BB +” bonds, for example, or high yield bonds that are rated only “C”. Although the specific exposure took place with duration, investors cannot have the same targeted exposure to the corporate bond market with ETFs.
As Sriharan noted: “Investors might find the BB space the most attractive, but currently cannot find an ETF that focuses on that. As an asset allocator, this is where I plan and hope the market goes. One can only assume that demand just hasn’t come for these specific ETFs yet. “
What is driving the growing demand for fixed income ETFs?
Another reason this is potentially very attractive, as Sriharan pointed out, is that active managers simply aren’t going to launch such targeted funds. In a space where active managers have traditionally been able to outperform due to the size and peculiarities of the market, this would be a huge compliment to investors.
How to defend against a possible spike in inflation is fast becoming the most important asset allocation decision over the past five years. For a while, issuers have offered exposure to inflation-linked bond ETFs, however, the market has seen a recent innovation that takes the space to the next level.
Obtaining inflation protection with golden ETFs has generally been a challenge due to the lack of short-dated golden bonds available. This means that investors are forced to own a version of golden bonds with long duration inflation protection instead, but it does not provide investors with a solid inflation hedge because the underlying bonds are. long-term and, therefore, generally underperform during periods of rising inflation.
As a result, Sriharan said the majority of investors focus on the US Treasury Inflation-Protected Securities (TIPS) market, which is more liquid and has short-term bonds.
The ETF market subsequently expanded to begin offering exposure to inflation expectations through break-even points such as the Lyxor US $ 10Y Inflation Expectations UCITS ETF (INFU). The problem with these strategies, Sriharan pointed out, is that they are sensitive to risk sentiment and therefore have a very high correlation with the equity portion of portfolios.
In response to this problem, Tabula Investment Management launched the world’s first ETF, the Tabula US Enhanced Inflation UCITS ETF (TINF), which combines TIPS and inflation expectations in the United States through breakeven points in October 2020. This is achieved by tracking Bloomberg Barclays US Govt Inflation- linked and long index on the Bloomberg Barclays US Government Inflation-Linked 7-10 Year Index and short US real returns via the Bloomberg Barclays US Treasury 7-10 Year Index.
This next-generation strategy is an example of innovation in the ETF space that provides investors with the tools to express specific views within a diversified portfolio and highlights the potential for further development across the board. the bond ETF market.
“It is certainly possible and for many investors the existing range of ETFs would likely be an appropriate and efficient way to gain exposure to fixed income securities,” added Mr. Limberis. “Thinking about what is missing or maybe what is lacking in flexibility when using ETFs, there are a few areas where some bond investors may want more choice, such as currency hedging. “
This article first appeared in Fixed Income Unlocked: ETFs Take Center Stage, ETF Stream report
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