The fixed-interest exchange-traded funds (ETF) market may only be small, at around 90 funds in the US compared with about 500 equity ETFs, but in terms of attracting new inflows the raft of launches in this sector last year has been extremely successful. Assets under management in fixed-interest ETFs doubled during 2007.
Much of this was down to the particular success of the new money market funds, which were launched largely in the second half of last year at a time when investors were nervous about corporate bond funds. The db tracker money market fund raised €1bn in its first three months, for instance, while Lyxor’s money market fund raised around €400m in its first three months.
“A lot of traditional money market funds were investing in subprime, but here was a very safe and secure product where the interest rolls up on a daily basis,” says Manooj Mistry, head of db x-trackers in the UK, an arm of Deutsche Bank.
“The fund is highly liquid and offers a very attractive rate of interest and only 15 basis points of fees. We recently looked at what deposit accounts are paying and the best was 3.2 per cent, while Eonia is paying 4 per cent, so even after charges it [the db fund] is still attractive, and you can hold as much as you want for as long as you want with no holding period or minimum size,” he says.
Db x-trackers launched dollar and sterling versions in Frankfurt and Milan at the end of January and is listing the range in London at the end of February.
Dan Draper, head of Lyxor ETFs UK, Ireland and the Nordic region, also attributes the success of the Lyxor ETF Euro Cash fund to ease of use.
“To invest in a cash deposit account or money market fund, hedge managers, private banks and institutional managers have to set up agreements and deposit a certain minimum amount. ETFs offer daily liquidity and are very easy to trade, even in very small amounts,” he says.
At the retail level, the fund has done particularly well in Italy where there are fiscal advantages in buying funds, because they are taxable at 12.5 per cent compared with the 27 per cent rate on bank deposits.
“Undoubtedly Lyxor ETF Euro Cash has a fiscal advantage, but on the other hand it has no fiscal advantage over money market funds, which share the same 12.5 per cent tax rate,” says Marcello Chelli, head of listed products, Italy, at Société Générale. “Furthermore, the fiscal advantage could be temporary because Italian politicians are dealing with the possibility of levelling all tax rates related to financial products to 20 per cent. Investors appreciated Lyxor ETF Euro Cash because it cannot lose value as its price grows every day, adding the new daily interest calculated using the Eonia interbank overnight bank rate.”
Transparency
There is no issuer risk or currency risk, says Mr Chelli, and the fund offers complete transparency and liquidity. “On Borsa Italiana, we continuously grant about €30m in bid and ask with a bid-ask spread of less than 1 basis point,” he adds. “Furthermore, the bid-ask spread is based on net asset value (NAV) and does not change all day (so it is absolutely fair). For all these reasons, the fund was undoubtedly the most successful story of the Italian ETF industry in 2007.”
Apart from the cash funds, bond ETFs can be split into two broad groups: those that track other asset class groups and those that reflect parts of Treasury yield curves. Providers generally offer funds based on the short, medium and long portions of the Treasury yield curve, and sometimes on five or six duration segments. The shorter ETFs are used by money market funds, and by managers needing to equitise their cashflows or for cash management when a fund attracts new inflows.
Longer durations are sought after by medium-sized pension funds looking to better match their liabilities. However, while a few local authority pension funds have bought into the market, the larger UK pension funds are generally geared up to arranging swaps to manipulate duration. “There has been a real spike in interest since the credit crunch,” says Mr Draper. “Investors that in the past used active bond funds have found that these have more credit exposure than they expected. Perhaps they thought they were conservative bond funds, largely government bonds with a bit of AAA rated, with just a little active risk, but in practice they had more exposure to credit than anticipated.”
Rather than pay total expense ratios of 0.625-1.0 per cent for a disappointing active bond fund, some investors have seen the attractions of paying just 15-20 basis points and knowing exactly what they will get for their money.
Among the asset class bond ETFs, some of the most popular are linked to the Lehman Aggregate, the widely used benchmark for the total investment grade market, which offers low credit risk, reasonably short duration and attractive yield. Other specialist ETFs offer exposure to different investment grades, such as at one extreme the iShares iBoxx High Yield Corporate Fund. Last July, for instance, db x-trackers launched three ETFs linked to the credit default swap index iTraxx, as a more liquid and transparent means of accessing corporate bonds, subsequently followed this year by the launch of bear, or short, versions based on swaps with Deutsche Bank. These funds carry slightly higher charges of 20-25 basis points.
Inflation-linked funds, such as Lyxor’s fund that replicates the EMTXi index, are attractive to any investor facing inflation-linked future commitments, such as insurers, mutual health organisations and pension funds. “The biggest users of fixed-interest ETFs are institutional funds of funds and all types of managers involved in balancing a portfolio across the range of asset classes, from balanced funds to tactical asset allocation managers, while the next biggest candidates are probably family offices and private banks,” adds Mr Draper.
Avoiding risk
Although derivatives are a compelling prospect for access to fixed interest, with good liquidity and lower costs, there are the governance issues in arranging swaps and what is known as basis risk in rolling over contracts from one quarter to the next, so ETFs have certain advantages over the derivatives market for long-term investors.
“A big segment of investors are not able to use derivatives, either for operational reasons or because their mandates don’t allow them to,” says Alex Claringbull, fixed income portfolio manager at iShares. “Even where they do, ETFs can be a more attractive proposition because in the derivatives space there is only one gilt future based off one 10-year government bond, whereas an ETF offers exposure to the entire curve in one trade. ETFs are also fully funded so there are no costs involved in rolling positions over. This exposure to the whole curve – rather than having to hold a whole series of segregated bonds – makes ETFs useful as a long-term asset allocator and cheap, efficient and quick tools that allow you to change your asset allocation at the touch of a button.”
Bond ETFs account for perhaps 20 per cent of the total UK ETF market compared with 10 per cent of the US market, which is skewed by long-established mammoth ETFs such as the SPDRs. For example, according to Dave Fry, founder of ETF Digest, three of the most popular bond ETFs in the US are the iShares Lehman 1-3 Year (SHY) with assets of $9.5bn; the iShares Lehman 7-10 Year (IEF) with $2.5bn and and iShares Lehman 20+ Year (TLT) with $1.5bn – still minuscule compared with their biggest equity peers.
“Demand is strong in the US because of its adviser culture, and the sector has recently been supported by the flight to quality and the widespread pursuit of assets that are non-correlated,” says James Ross, senior managing director at State Street Global Advisors, which launched seven bond ETFs last year. “Use of advisers is growing in the US and they are devising asset allocation models that require instruments that are liquid and easy to switch, using ETFs to deliver cost effectiveness and ease of access. Many are putting these bond ETFs into wraps and so with the wrap fee on top, the cost effectiveness of the underlying funds is important.”
“Bond ETFs are becoming more popular as investors diversify out of stocks and see that it makes sense to put a chunk into bonds,” says Mr Fry. “However, there is really not much to differentiate the offerings, with the result that established providers such as State Street and Barclays are trying to compete on price.”
NEW FRONTIERS AND FURTHER INNOVATION
On the equity side of the ETF market, the Middle East and Asia are of continuing interest, and fund launches are also expected that split the Bric (Brazil, Russia, India and China) countries. The so-called frontier emerging markets are an interesting prospect but as yet are insufficiently liquid to track properly. However, trends such as the listings of previously state-owned enterprises in Eastern Europe are gradually releasing liquidity into the region.
“A common model over the past year has been the use of international ETFs as a core with overweight positions in specific emerging markets bolted on,” says James Ross, senior managing director at State Street Global Advisors.
This trend is expected to continue as developing the expertise to stockpick across emerging markets is an expensive, hit-or-miss business for fund management houses. Funds of funds increasingly use ETFs to fill the gaps in their regional expertise, and there has also been talk of the launch of a passive fund of funds based entirely on them.
A lack of differentiation between product offerings is likely to drive further innovation and continue to put pressure on charges. Vanguard, for example, makes the case for its total bond ETF tracking the Lehman Aggregate that it holds over 3000 issues and is regularly monitored and risk-assessed by sector and industry weightings.
 | Other funds that track the index have smaller baskets and, as a result, greater tracking noise, says Gregory Davis, principal and senior partner at Vanguard. Innovation will also continue to be driven by scepticism that outstanding active managers are easy to identify and can consistently produce good returns. Wealth managers in particular seem to see a value in avoiding the manager search process. |
Unsurprisingly, interest in asset-backed ETFs was evident last year but has evaporated rather quickly. Attention has now turned to inverse or bear funds, with narrower targeting than the original Proshare and Rydex prototypes.
