Providers rush to meet demand for fixed income ETFs

Exchange traded funds (ETFs) have developed from a $416bn (€333bn) market in 2005 to $2.5tn today, and are still growing at a furious pace. Assets gathered in the first 10 months of the year topped $73.3bn, already overtaking the annual record of $70bn set in 2012. Only 3-4 per cent of European mutual fund assets are in ETFs compared with 10-12 per cent in the US, so there is much potential growth in the European ETF market generally.

“One reason is the big increase in independent financial advisers outsourcing investment management to discretionary managers who are using model portfolios – at the expense of active management,” says Tim Huver, ETF manager for Vanguard in Europe. “It is a misconception that ETFs are only used for short-term trading; there has also been an increase in long-term adoption from Buy and Hold investors.”

There has been a devolution from institutions to advisers and to self-directed retail investors, he explains, and while ETFs are mostly used for cash equitisation and rebalancing and transition management at the moment, they are also not uncommon, for example, as part of a 401k product offering.

Much of the inflows, especially into mainstream benchmark exposures, have been from institutions switching out of existing futures positions and looking to maintain their exposures but holding it in a different way.

One factor is the march to low charges in the industry. “A continued positive development for investors is lower charges on mainstream indices,” says Arne Noack, Deutsche Asset & Wealth Management’s head of exchange traded product development for Europe. Deutsche charges 0.09 per cent for exposure to the Eurostoxx 50 Index and 0.07 per cent for MSCI USA exposure.

Trading spreads meanwhile have also come in. Investors are increasingly looking at the total cost of ownership, which covers the costs of entering, holding and exiting a position. “As this is now extremely competitive for ETFs, it has brought ETFs onto the radar of people who had not looked at them before,” he adds.

While equity ETFs are still growing strongly, the exponential expansion has come on the fixed income side. One third of new assets collected this year  have been in fixed income compared with around 20 per cent the previous year. For example, in October fixed income accounted for  $19.9bn of the month’s $37.3bn inflows. High yield corporate bond ETPs also had its best month of the year attracting $2.3bn, as interest rates fell further.

ETFs are very relevant in the bond space for both tactical positioning and for long-term holdings, says Mr Noack. Direct bond investment requires admin processes for reinvesting in companies and for managing bonds as they mature, or if they mature out of the maturity bucket chosen. Sovereign bonds are more standardised, but some paper such as leveraged loans do not even have standard settlement times, he claims. In the US there are leveraged loan products that charge 0.65 per cent, and high yield products in Europe that charge 0.4-0.5 per cent.

“We believe fixed income ETFs are a compelling offer, and that this is an area where we will continue to see strong inflows and developments,” says Mr Noack.

The race is on to capture these inflows with novel fixed income products. Amundi has launched an ETF tracking a floating rate note (FRN) index that is not sensitive to government interest rates as it is issued on the Euribor. 

The Pimco Short Term High Yield Source ETF has attracted more than $800m from investors who need high yield but want to minimise volatility, and are aware that long duration outperforms only in a strong credit market.

“Currently there are products that cover the spectrum of the yield curve and short duration but the market is lacking a three to five year duration product on UK Gilts for example – there is not a product to express this particular view,” says Chanchal Samadder, head of UK ETF Sales at Lyxor.

“Asset managers and wealth managers want these more specific exposures. We’ve had clients ask us about FRNs, loans, convertible bonds – in Europe such  ETFs scarcely exist.”

Dividends have always been a strong story, linked as they are to a company’s health, and  Lyxor’s fundamentally-based Global Quality Income ETF has been popular. 

“Dividends are an easy story to understand but the alternative methodologies differ a lot – some just weight purely by dividends  which is not a great way of doing it,” says Mr  Samadder.  “A stock that has an unusually high dividend  of 7-8 per cent could reflect either the stock price has fallen massively or the stock will have a problem covering it. Investors want a stable and ongoing dividend so need to consider balance sheet metrics.”

In the US, Wisdom Tree is known for its dividend funds, which are based on dividends paid, not yield. Its European small cap fund has been doing particularly well this year.

Wisdom Tree’s Boost ETP range of short and leveraged products have also been doing well against the recent backdrop of increased market volatility, recently trading record volumes such as $285m for October, a 33 per cent increase from the previous record in September, owing to increased volatility over this period.

 “They are an easy way to get exposure and can be traded through an ordinary brokerage account,” says Nik Bienkowski, co-CEO of Wisdom Tree Europe. “While some of the products are leveraged, they may appeal to some retail clients because unlike CFDs (contracts for difference), you cannot lose more than you have invested and the ETPs are highly transparent.”

Fixed income does present problems for smart beta product structuring, however. “For bonds, the market is not as advanced and there is no consensus on ways to approach fixed interest for smart beta,” says Matthieu Guignard,  global head of product development and capital markets at Amundi ETF & Indexing. “The availability of data is also an issue as bonds are traded over the counter.”

The other big shift in the market has been from single strategy smart beta products to multi-strategy products.  The most popular single strategy product has been minimum volatility, but providers including Amundi and  Source are increasingly combining risk factors such as low beta, size, value, momentum, quality.

“This trend was very strong in the US where the market is more mature than in Europe,” says Mr Guignard. “Investors started to shift to smart beta and noticed that the low volatility strategy was a good one in bear markets, but in bull markets you lose part of the return, so investors began to mix other smart beta strategies together that would do well whatever the market conditions.”

Amundi’s new launch is based on an Edhec Risk Scientific Beta index which combines four risk factors  – momentum, size, volatility and value. “ERI Scientific Beta is a first mover but other major index providers are looking at the same approach,” says Mr Guignard. “Strong research capabilities are required for this and when it comes to risk factors other than minimum volatility, not many providers are offering a combination of risk factors and weighting schemes.”

Using fundamental weightings in place of market cap ones can improve a portfolio’s  Sharpe ratio, according to Edhec researchers who back-tested the  performance of multi-strategy equity indices using a combination of value, momentum, size, and low volatility factors over a range of geographies over 10 years.

The Sharpe ratio for the smart beta indices was 0.47, compared to a traditionally-weighted portfolio reading of 0.34, which was partly a result of lower volatility. The most marked difference occurred in developed Asia-Pacific markets ex-Japan where Sharpe ratios were up 0.21 from the traditional benchmark’s reading of 0.43.

“Institutional investors were the first movers,  including some large pension funds which are traditionally early adopters of innovative investment approaches,” says Mr Guignard.

The first movers to smart beta were the satellite parts of portfolios because they were testing how smart beta behaves, he explains.  “A good way to do this was to buy a style strategy, but now we are also seeing smart beta being used for the core part, mainly multi-strategy approaches. It can then be seen as an all weather core that corresponds with the way many investors look at their portfolios through a risk approach.”

The switches are coming from both traditional passive approaches and active management. Where there is significant tracking error, the switch will likely be from actively managed portfolios.

“We expect multi-strategies to be used more frequently in future,” says Michael John Lytle, chief development officer at Source.  “As low volatility strategies underperform in rising markets, it will be interesting to see how much investors are willing to make that trade off. Some strategies have more relevance and can work across all market cycles.”

The best first product to do was global as it offered the greatest range of different countries, but some products could have a more geographic focus and Source is working on those, adds Mr Lytle. “However, it cannot be too small a market.  Broader indices such as a world index have in excess of 1500 companies, and you do need several hundred.”

Deutsche has taken a slightly different approach in launching a series of separate global equity factor funds based on value, momentum, quality and low beta in October. Most of the initial demand is for value and low beta, with investors expected to switch between the four styles depending on the environment.

“The strategic beta space has become more competitive,” says Mr Noack, and he believes the new products which emerge will be more granular, and take-up will depend on the usefulness of that granularity.

“We may see smart beta products emerge based on regional groupings of stocks, rather than global groupings, but at a certain point the granularity reaches its limit,” he explains.

“The Dax only has 30 stocks for instance, which means it isn’t really diversified enough to then apply smart beta type filtering to get a meaningful result. The resulting portfolio would be too concentrated, so these processes are not infinitely applicable.”

The industry recently encountered a setback when the Securities and Exchange Commission (SEC) rejected a proposal by NYSE Arca to allow trading of a new type of non-transparent managed ETF that would disclose holdings quarterly instead of daily, and could be seen as the next step in ETF evolution.

The SEC has denied similar requests by BlackRock, Precidian Investments, Capital Group, T. Rowe Price and Eaton Vance. The proposed structures would allow the funds to remain priced in line with assets, without revealing specific positions. Asset managers argue that the requirement for daily disclosure of holdings would make it easy for competitors to copy, and traders to anticipate, portfolio changes, but the commission is concerned about the liquidity and efficiency of this structure.

Historically, ETFs have been connected to events in the market such as the Flash Crash in 2010 when the Dow Jones plunged about about 9 per cent, only to recover the losses within minutes, and there is still nervousness in some quarters. A prime concern is liquidity in a correction. For example , not all the 46,000 separate corporate-bond issues will find ready buyers during a crash which could prompt a fire sale. On the other hand, corporate-bond ETFs amount to $141bn, tiny compared with annual bond issuance of $3.2tn in 2013.

Liquidity was tested during the taper tantrum when BlackRock’s high-yield ETF traded $1bn in a day, briefly dipping to a discount of 2 per cent to its net asset value, but recovering equally quickly.  

Smart beta strategies yet to gain traction

As yet wealth managers are relatively conservative about smart beta strategies, and critical of their pricing.

“Within the smart beta universe we currently only recommend a US strategy that aims to generate high quality income,” says Shakhista Mukhamedova, fund research analyst at Brewin Dolphin. The SPDR S&P US Dividend Aristocrats Ucits ETF invests in the US companies that have been able to grow their dividends consistently over the previous 20 years. This strategy has a defensive bias and, unlike crude yield ETFs, holds up well during periods of increased volatility, he says.

“We like risk factor strategies, in particular those that combine value and momentum factors,” explains Mr Mukhamedova. These typically exhibit low correlation to one another, under most market conditions. The combination, therefore, renders funds of this type less vulnerable to significant style rotations in the market.

 “More broadly, however, and despite our preferences for various factor combinations, we are yet to find an appropriately priced product across the smart beta universe,” he says. “Providers need to get real if they are to crack the UK wealth management market. Yes it might be smart beta but it is also ‘dumb pricing’.”

 Mr Mukhamedova describes minimum variance as another “buzz” area, where strategies optimise stock combinations to achieve the lowest volatility portfolio on offer from within a specific universe.

“In more volatile areas of investment, such as Asia and emerging markets, we would consider achieving exposure via minimum variance strategies, but see little need given the confidence we have in our active fund picks,” he explains.

Investors have shown more interest in this “beta light”, says Paul Stefansson, managing director, UBS Investment Products Singapore.

“This strategy allows them to avoid some downside risk of equities but still capture most of the upside,” he says. Since 2008, some “minimum variance beta light” equity funds have allowed investors to capture 70 per cent of the gain but only feel 50 per cent of the loss.

“However, as the quant crash demonstrated, these popular beta light funds will need to avoid crowding to ensure future gains with less volatility,” adds Mr Stefansson.

VIEW FROM MORNINGSTAR: Contrasting fortunes

Over the past 12 months, returns on European-domiciled ETFs have highlighted the stark contrast in fortunes between European and US equity markets.

ETFs tracking US large-caps such as the iShares S&P 500 and Vanguard S&P 500 ETF have performed particularly well with annual returns topping 17 per cent. The continued recovery of the US economy has helped propel the S&P 500 to historic highs.

In contrast, funds tracking European large-caps have been suffering the effects of an economic headwind. The iShares Euro Stoxx 600 has returned a meagre 2 per cent over the same period. This reflects the health of eurozone economies which, despite the European Central Bank’s best efforts, are still struggling for growth.

When examining fund flows for the year, a similar story emerges. US large-cap equity ETFs have seen net capital inflows of more than €10bn, a figure which dwarfs the €1.4bn which flowed into eurozone large-cap equities. These flows can be used as a barometer for investor sentiment, and clearly show European investors’ relative preference for US equity exposure.

Elsewhere, returns on precious metals have been muted. Gold prices, which traditionally fall in the face of a strengthening dollar and rising inflation, have tumbled as colour has returned to the cheeks of the US economy. The ETFS Physical Gold, Xetra Gold and ETFS GOLD Bullion Securities have declined by 20 per cent over the past three years.  While all three products suffered net outflows of capital this year, the ETFS GOLD Bullion Securities ETC suffered most, losing almost €500m in AUM.

Kenneth Lamont, fund analyst, Morningstar