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Fixed income exchange-traded funds (ETFs) enjoyed a boom last year as cost-conscious investors sought yield amid weak equity markets. By the end of 2011, fixed income ETF assets stood at $12 billion, a 43% rise from the end of 2010, according to Investor Economics.

The number of funds also increased dramatically—about two-thirds of the category’s 55 funds were launched in the last two years and 26 new fixed income ETFs were created in 2011.

“There’s definitely been a surge in ETF assets,” says Sandeep Gosal, senior analyst, Investor Economics. “During the market downturn of 2008, we started to see a lot of money going into money market funds. But as yields started to drop closer to zero, you started to see an increase towards fixed income funds.”

ETF giant iShares—which manages the bulk of ETF assets in Canada and whose parent company BlackRock bought rival Claymore in January—says Canadian ETFs took in $7.9 billion in net new assets in 2011 and of that, over 40% or $3.3 billion went into fixed income ETFs.

There are several reasons why fixed income ETFs have become popular with investors, the most obvious being cost.

As of the end of 2010, fixed income ETFs had an asset-weighted MER of 31 basis points, according to Investor Economics. Fixed income ETFs that pay a trailer to advisors had an MER of 79 basis points.

By comparison, actively managed fixed income mutual funds had an average asset-weighted MER of 138 basis points, which includes a trailer fee. Stripping out the trailer, the MER averages 74 basis points.

“Investors are voting with their dollars,” says Mary Anne Wiley, managing director and head of iShares for BlackRock Canada. “In a low yield environment, the more you can reduce your cost, the more you’ll have in your portfolio or your pocket,”

Gosal notes that there is also a brokerage cost associated with ETFs, essentially a trading fee ranging from $5 to $30 per trade. “That’s another consideration to keep in mind when looking at and comparing fees between ETFs and mutual funds.”

For the vast majority of investors, an ETF or mutual fund is preferable to investing directly in individual bonds.

“Fixed income securities don’t trade on an exchange so they’re over-the-counter and there’s not a lot of transparency around the pricing,” Wiley says. “Even if you negotiate a good price through an advisor, when you put it into the hands of a large asset manager, they’re going to have more pricing power because they are working all day, every day with the various counterparties.”

Other than price, access is a key consideration for investors choosing between ETFs and investing directly in the bond market. “If you think of traditionally building out a bond portfolio, having to buy the names individually, and bonds are sometimes hard to access as an individual,” Wiley says.

“You could get a handful of bonds or you could buy an ETF that gives you very broad diversified access to the whole category—depending on the segment you’re buying you’re talking about hundreds of securities. So this makes it easy and efficient to trade fixed income.”

Superior liquidity is another advantage of ETFs, says Wiley, noting the structure combines the best aspects of a mutual fund and a stock.

“You’re getting broad exposure to the market like a fund, but it trades on the exchange like a stock which means investors can get in and out of a position very easily and fine tune their portfolio; in this market environment that becomes very important.”

This makes rebalancing relatively easy. If an investor expects a change in interest rates, he or she may want to shorten the duration of their fixed income portfolio to reduce interest rate risk. The fixed income ETF universe includes both short- and long-duration mandates, allowing the investor to reorient their exposure with two quick trades.

ETFs also offer advantages over the traditional mutual funds, as active managers may take on more risk in an effort to outperform their benchmark.

“When we look at the history and the data, it tells us that active management is really hard to do,” Wiley says. “Managers don’t consistently outperform the index. When you look at fixed income, the range of those able to outperform is fairly narrow.”

“If you can get access to the market at a low cost, and just mimic a segment of the market, driving your costs down in a low interest rate environment, chances are you’re going to be better off.”

Wiley believes ETFs will continue to grow in popularity for fixed income exposure. Investors need a bond component in their portfolio, she notes, and an ETF is going to be “one of the most efficient and effective” ways to get that exposure.

“I don’t see demand for income going away anytime soon,” she says. “Anything that gives an investor a steady stream of income is going to be appealing and fixed income ETFs are going to meet that demand.”

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This Special Report is sponsored by: iShares