Fixed income ETFs can never live up to the claim they offer an inexpensive way to buy the market, with some of the most popular funds not even trying to replicate the index investors may assume they are tracking, according to David Ennett, head of High Yield and colleague Jack Holmes, co-managers of the Kames High Yield Global Bond Fund.
While there have been significant inflows into bond ETFs in the last 12 months, investors may not completely understand what they have bought and how they perform against their own benchmarks.
Fixed income ETFs may be rising in popularity, but we believe their true nature is not completely clear to investors. Trackers may claim to let you inexpensively buy ‘the market’, but in truth they can’t.
Bond indices have thousands of constituents and so full replication of the market isn’t practical. Even by attempting to copy the index, passives incur high trading costs which eat away at returns, much more so than the low management fees suggest. And without experienced managers at the helm, in times of stress an ETF can trade at material deviations from its net asset value given the liquidity landscape of high yield.
For these reasons, many passives don’t even try to track the market. For example, the iShares $ High Yield ETF sets its benchmark as the iBoxx $ Liquid High Yield index, which is a subset of the broader high yield universe. This subset has about half the number of bonds – circa 1,000 versus 2,000 – versus the dollar high yield market (as measured by Merrill Lynch) while its ratings, sector and country skews are different. These differences are evident from the performance of the index versus the ‘real’ market. Not only does the ETF not track what investors think it’s tracking, it fails to keep up with its own benchmark.
These are far from the only pitfalls of investing in fixed income ETFs. These funds are designed to buy the most indebted issuers, offer no duration management (rather unwanted duration extension), have significant concentration risk, with little liquidity management, and no ability to take advantage of the inefficiencies and opportunities the bond market offers.
So when investors assess if a fund has beaten the market they need to consider what they mean by ‘market’. Do they mean an index – aka a spreadsheet – that enjoys immediate, infinite, and costless liquidity, or the closest thing to it, ETFs which have to operate, like us, in the real world?