ETFs: How investors are embracing bond ETFs as ‘active’ tools

Technological advances are rapidly transforming the investment landscape, with traditional methods of investing being rethought and modernised. This disruption is also becoming apparent within the fixed income industry with the rise of ETFs.

Investors are no longer able to rely on the traditional bond trading model to meet all their liquidity needs. Regulatory changes have reduced large banks’ balance sheets, constraining their ability to hold inventory and support market liquidity. It is now harder and more costly for investors to source bonds and to quickly adjust their portfolios. As a result, investors are turning to ETFs as a way to invest in the asset class.

A bond ETF consists of a portfolio of bonds that is traded intra-day on an exchange, like an equity security. iShares launched the first US fixed income ETF in 2002. Since then, there has been a proliferation of fixed income ETFs launched covering a multitude of asset classes and sectors in the bond market. Investors are now able to select ETFs that target specific sectors, maturities and/or credit quality ratings.

The range of exposures available help investors to build well-diversified portfolios which would otherwise be challenging, if not impossible, for all but the largest investors, given the high denominations of most bond issuances. Not only can investors seek better diversification, ETFs also afford flexibility and precision that mean portfolios can be tailored to meet investor risk profiles, target outcomes or navigate specific market events.

Bond ETFs have also proved to be a dependable solution during periods of market volatility. They have come into their own during tough market environments as they did during the volatility spikes in December 2015 and during the 2013 taper tantrum, when investors were able to turn to ETFs to quickly and effectively trade risk.

More broadly, investors are seeing the benefits of using ETFs for both core holdings and tactically. Investors are making active decisions about their asset allocation, including which tools to use, and blending passive and active solutions to express those views.

To illustrate this, investors are using ETFs to access the full range of fixed income assets from government and investment grade corporate bonds through to high yield and emerging market debt but with the ability to be flexible in asset allocation decisions. For example, over the last year investors have used inflation-linked exposures such as Treasury Inflation Protected Securities (Tips) to help protect portfolios against potential increases in inflation. Recently bond ETF flows have moved towards shorter duration Treasury ETFs and interest rate hedged exposures. These seek to protect against increasing interest rates, and reflect investor concern about interest rate hikes.

All in all, the growth of bond ETFs is symptomatic of the increasing popularity of ETFs more broadly both in the UK, and globally. Global assets in bond ETFs reached a record $650bn as at the end of 2016 reflecting this growth. iShares predicts assets to surpass $2trn by 2025 as the products are adopted by a broader range of users, and particularly in the retail space where platforms and advisers are becoming more comfortable with the products.

As ETFs continue to democratise investing, we expect to see a change in mindset from active managers, which will see ETFs viewed simply as part of an investor’s toolkit, and used as both core building blocks and tactical exposures.

Brett Pybus is head of iShares EMEA bond ETF strategy at BlackRock