Mechanics of fixed income ETFs and benefits for investors

Investors looking to add fixed income exposure to their portfolio, whether to generate additional income or help reduce volatility, have tended to buy traditional mutual funds. While fixed income ETFs make up around 25 per cent of the European ETF market, they may not be the first place many investors look. However, we think there are several reasons why they should at least be in the frame.

First of all, it is worth pointing out that the general benefits of ETFs also apply to fixed income ETFs. They offer transparency, trade throughout the day, and are typically cheaper than comparable mutual funds. In addition, an investor can gain access to a broad segment of the fixed income market using a single trade that provides exposure to a diversified basket of bonds. Many fixed income ETFs invest in the underlying bonds, which is important to some investors who want to know their money is being invested in the physical assets of the index.

Moreover, the sheer size and diversity of the fixed income market results in very different bond issuers having similar credit ratings, highlighting the complexity this poses to a typical investor. Investing in an ETF that applies certain criteria can help an investor filter through the investment options. If you think about the broad investment grade market, there are names that are deemed “safer” than others, even if they have been given the same rating by third-party agencies such as Standard & Poor’s, Moody’s or Fitch.

If two bonds have similar yields and maturity profiles, but one is deemed riskier than the other, an investor may consider investing in the lower risk option. However, not all ETFs are created equal and some ETFs only aim to replicate a broad index without applying additional filters that may exclude riskier bond issues.

This is where fixed income ETFs can come into their own, with smart beta and actively managed funds both aiming to manoeuvre around this potential pitfall. This is also where some active management strategies have enjoyed success in generating better risk-adjusted returns versus the broader indices.

Smart beta ETFs

Investors are hopefully getting used to the term smart beta, although they arguably think of it from an equity perspective. That’s fair considering the majority of smart beta ETFs are in the equity asset class. For review, smart beta refers to a rules-based strategy that automatically selects and weighs constituents by a method other than just market cap weighting. That means they typically fall within the passive space, as there is no human intervention – or emotion – in the selection process.

Actively managed ETFs

In contrast, an actively managed fund will have an element of human intervention. With fixed income ETFs, the offerings may range from full active management to just an overlay of the automated process, where an index is created based on predefined criteria, and the fund manager makes a judgement on which holdings to remove.

Whichever method is used – active or smart beta – the idea usually involves developing funds that aim to generate better risk-adjusted returns. This may be to take a diversified index and, by removing the riskier names, help to reduce some of the risk in the portfolio. It may also be to take the same diversified index and focus on getting the most yield for a given level of risk.

Reducing risk or enhancing returns can appeal to many types of investors and, in time, we believe they will start focusing more
on ETFs.

Lidia Treiber is a director and fixed income specialist at Source.