Bond ETFs are set to boom

Innovations in fixed-income ETFs may help them catch up with their equity-based peers

Bond ETFs are set to boom
The ETF industry has exploded to reach US$4 trillion in assets this year, with much of the growth driven by innovations in equities. But with investors hungry for new products and fund providers eager to deliver, it may be time for bond ETFs to take a bigger share.

With some analysts calling an end to the bull market in fixed income, more investors are ready to go beyond simple bond bets and explore more innovative solutions, according to the Financial Times. One segment set to benefit is factor investing, otherwise known in the ETF world as smart beta.

While there’s been much experimentation in smart-beta equity ETFs, bond ETFs have tended to be fairly plain. Financial engineers at big asset managers are changing that, producing next-generation fixed-income ETFs that go beyond simply mimicking a bond index’s performance.

One can see the developing story in bond ETFs through Morningstar data. Less than a decade ago, the research firm had only two “non-traditional” ETFs registered, both run by Invesco’s PowerShares, with assets of around US$200 million. Today, Morningstar tracks 23 such ETFs with assets totalling nearly US$10 billion.

Morningstar’s catalogue of non-traditional bond ETFs is still worth much less than the US$600 billion amassed in smart-beta equity ETFs, but industry insiders are predicting a pickup. BlackRock has tallied 25 smart-beta bond ETFs; Rob Nestor, head of BlackRock’s US iShares smart-beta team, has said there are another 25 awaiting approval from the Securities and Exchange Commission.

The smart-beta game is played by considering factors other than capitalization in determining the weights of a portfolio’s individual holdings. This makes sense particularly in fixed income, where companies that have a bigger presence in bond indices are typically more indebted.

“Investing more in the biggest issuers of bonds isn’t necessarily the best way to invest in fixed income,” Todd Rosenbluth, director of ETF and mutual fund research at CFRA, told the Times. “The next wave [of ETFs] will be these new smart-beta bond products. We’re starting to see it.”

Experimentation in bond ETFs has been anaemic compared to that in equity ETFs partly because academic research has been focused on the latter. Researchers can access extensive and clean data on equities going back many decades, whereas public reporting of corporate bond trades began only in 2002.

“A lot of bonds are issued by companies that aren’t public, and even the price data can be hard to come by,” said Rob Arnott, who heads investment firm Research Affiliates and is a smart-beta pioneer.

The gap between fixed-income and equity ETFs is also partly due to fundamental differences between stocks and bonds. Riti Samanta, head of smart-beta fixed income at State Street Global Advisors, noted that bonds only trade intermittently, making the construction of liquid, alternative indices to track much more difficult. Buying all the holdings in an index is also much easier for equity funds compared to bond funds.

While smart-beta bond funds are an entirely new animal for many investors, they still behave following a fundamental financial principle: they can deliver higher rewards, but at a correspondingly higher risk. Still, as ETFs continues to break records and returns get harder to come by, it might be high time to explore new territory in the fixed income space.

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