ETFs fit the bill for fixed-income allocation

Fixed-income ETFs hold significant potential for institutional investors, who are using them in increasingly sophisticated ways. The fixed-income ETF market includes diverse sectors that allow investors to enhance portfolio performance, mitigate risk and improve efficiency. Plus, the liquidity that fixed-income ETFs can achieve, along with two-sided pricing transparency, is attractive to investors looking to gain expedient, tactical exposure.

Advisors can apply techniques used by institutional investors to form their own client portfolios during these volatile times.

Liquidity Fixed-income ETFs are dependable investment vehicles for institutional and retail investors. For example, during the recent economic crisis when credit markets were frozen, fixed-income ETFs continued to trade and provided a price discovery mechanism that reflected market risk and investor sentiment. Although at significantly decreased prices, fixed-income ETFs continued to trade even as bond markets seized. There are multiple layers of liquidity available through fixed-income ETFs: contingent exchange, underlying bond market and observable exchange liquidity (the average daily trading volume, ADV).

The advantage of accessing the over-the-counter (OTC) fixed-income market through an ETF is in the top two layers of liquidity, the secondary market and the ETF market. Once a fixed-income ETF gains critical mass in exchange liquidity (not necessarily AUM), it is possible to execute fairly large trades through the exchange without having to access the underlying bond market (i.e., the exchange liquidity layer absorbs flows without necessarily triggering ETF share creation/redemption through the underlying bond market).

As fixed-income ETFs grow in trading volume, larger trades that often exceed ADV clear with minimal impact. This is a reflection of the contingent layer of exchange liquidity. For retail investors, additional exchange liquidity can be unlocked as a result of execution, using strategies such as marketable limit orders, which are limit orders above or below current market prices. Limit orders are designed to take advantage of the flexibility of ETF supply and demand at varying price levels.

In these instances, tactical trading flows can be triggered at levels removed from current market price. Maximizing the first two levels of liquidity creates the opportunity for investors to trade a round-trip for pennies in markets that normally trade in points.

Advisors can also use fixed-income ETFs during portfolio transitions. For example, to gain interim market exposure, retail investors can invest new contributions of money or one-time windfalls into an ETF while securities are sourced for a new portfolio.

Tactical allocations Institutional investors, particularly levered relative-value investors such as hedge funds, and long-only investors such as mutual funds and pension funds, have found index-based fixed-income ETFs offer rapid, efficient allocations to specific fixed-income sectors.

Based on market views, such investors may quickly increase or decrease beta exposures to target sectors more precisely and efficiently through ETFs than could otherwise be accomplished using the underlying OTC bond or derivative markets. The instantaneous diversification provided by fixed-income ETFs makes this application relevant even for the most novice retail investors.

You can help your client build market exposures through directly acquiring individual cash bonds. This strategy works in instances of high liquidity, such as Government of Canada bonds, but is less likely to be achievable in high-yield or emerging markets because it is costly and time-consuming to make an allocation to a broad range of illiquid cash bonds.

On the other side, the ETF structure allows investors to achieve desired broad market exposure in a quick and efficient manner, a key value of fixed-income ETFs. Taking these factors into consideration, investors can overweight sectors they believe will perform better based on market risks, while underweighting those they believe will decline due to investor sentiment, inflation or a declining economy.

Unlike the traditional bond market, which is often neither liquid nor price-transparent, fixed-income ETFs allow investors to adjust their exposure to specific sectors easily and transparently.

Fixed-income investments fluctuate in response to market and economic events. It’s often challenging for retail investors to maintain target market exposures in volatile markets. A sudden equity market rally accompanied by a sell-off in bonds can lead to being overweight in equities.

Fixed-income ETFs may be used in conjunction with ETFs in other asset classes to provide a liquidity reserve for core investment strategies. This reserve allows investors to quickly and efficiently bring market-driven exposure mismatches back in line by increasing or decreasing ETF holdings.

Quantifying value Institutional investors have a systematic method of quantifying the cost of executing a given investment strategy, including investing in fixed income or fixed-income ETFs. Three metrics are used: implementation cost, implementation delay tracking and portfolio construction tracking error. They’re used to compare investing using fixed-income ETFs to using bonds directly or to compare one ETF to another.

Implementation cost: Depending on transaction size and holding period, the ETF structure may result in a lower all-in cost for the investor relative to individual bonds.

From a cost perspective, an institutional investor’s decision on whether to implement a beta strategy with an ETF or a cash bond portfolio will be a function of:

• Underlying bond bid/offer spreads;
• ETF bid/offer spreads and market impact;
• ETF management fee and trading costs (commissions), and
• Desired holding period.

For example, when comparing the management fee and bid/offer spread of an ETF versus the bid/offer spread of investment-grade cash bonds, the lower transaction costs of the ETF often compensate for the effects of the management fee, resulting in lower “all-in” costs.

This effect is most pronounced for short holding periods, but is often valid for holding periods of up to five years. Despite the management fee, the ETF structure is a cost-efficient access point to a variety of fixed-income sectors. The attractiveness of a fixed-income ETF relative to the underlying bond market is driven by the strength of exchange liquidity and the implementation costs.

Implementation delay tracking: Cash bond portfolio allocation requires time to implement. Once the deal is done, the investor may be underinvested relative to her targeted exposure. In some cases, it could take up to four weeks to assemble a cash bond portfolio with bond purchases happening over the same time frame. This underexposure represents a risk to the investor. In comparison, a similar exposure implemented using an ETF could likely be achieved within a single day and often with a single transaction. This situation allows the investor to eliminate the risk from implementation delay.

Portfolio construction tracking error: Investors could also mitigate delay risks by assembling a portfolio with a smaller number of bond positions and achieving a full investment in a faster time frame. But this strategy results in a greater risk of tracking error versus the target benchmark. The smaller, less diversified portfolio will also result in a higher level of idiosyncratic risk.

Although it is often thought that a portfolio of as few as 30 securities may significantly reduce idiosyncratic exposure (leaving only systematic or market risk), certain fixed-income sectors (e.g., high yield) require far more securities to achieve this result. Since ETFs hold fully diversified portfolios, investors can express tactical views using them without needing to be worried about a trade-off between diversification and the speed of implementation.

Many fixed-income ETFs have a robust level of exchange liquidity apart from the underlying bond market. Fixed-income ETFs continue to grow rapidly in assets and familiarity. With the ETF structure, investors can get swift fixed- income exposure in transition management, cash deployment, tactical allocations and more.

Mary Anne Wiley is managing director and head of distribution at ETF provider iShares Canada.