Global investors are increasing their allocation to Asian fixed income as the markets offer attractive yields compared to many developed markets and have become more liquid and matured. As such, Exchange-traded funds (ETFs) are fast becoming their investment of choice.
A new survey of institutional investors by Greenwich Associates* reveals that 24% already have a stake in Asian fixed income ETFs, making them the most popular passive fund option. A further 22% are also considering adding them to their portfolios – giving these funds the highest potential growth rate among all possible investment vehicles.
Yet, several common misconceptions about fixed income ETFs still linger. We will investigate the most pervasive ones, aiming to separate fact from fiction.
MISCONCEPTION 1: FIXED INCOME (FI) ETFs DISTORT THE UNDERLYING MARKETS
Have fixed income ETFs become so large they can now distort the underlying bond markets? Since the global financial crisis, the demand for these funds has grown exponentially. In 2008, assets under management in fixed income ETFs represented $48 billion and around 1.9% of the global fixed income fund industry, according to Morningstar. As of 30 June 2019, the size of assets exceeded $1 trillion.
Because the growth of these instruments has been robust, it’s no surprise that allegations of bond market distortion have emerged. But in fact, the growth of ETFs has kept pace with that of the overall market. The total investable fixed income universe now stands at $105 trillion, meaning fixed income ETFs still only account for less than 1.5%. Hence, their influence on prices is limited.
Further, rather than altering the landscape, they are, in certain sectors, an important source of additional liquidity. For instance, some equity investors now use these vehicles to express a fixed income beta exposure in both directions – this two-way flow in ETF shares also largely negates their impact on the market.
MISCONCEPTION 2: FI ETFs ARE NOT SUFFICIENTLY LIQUID
Some investors remain cautious of fixed income ETFs, holding back because of fears that volatile markets may strangle liquidity. While these fears are understandable, they are also misplaced. In reality, a fixed income ETF’s liquidity is at least as liquid as the underlying market that it tracks.
The reason for this has to do with how fixed income ETFs and bonds trade. The bond market is different from the equity market – it is not centralised, operating through a dealer network with each one offering a separate liquidity pool. It is therefore not only more opaque, but also more operationally complex to trade multiple securities in a single execution.
The fixed income ETF market, on the other hand, has a two-tier liquidity system. The primary market is where ETF shares can be created and redeemed, and the secondary market is where ETF shares are listed and traded on exchanges. Normally, investors buy or sell ETF shares via the secondary market. However, if their buy or sell order is too large to trade on the exchange, the creation/redemption mechanism will be able to accommodate large buy or sell orders beyond the liquidity provided by the secondary market. Therefore, investors can still trade in the primary and secondary market, even if the underlying bonds become illiquid, such as in times of high volatility.
MISCONCEPTION 3: FI ETFs ARE UNSUITABLE FOR NICHE MARKET EXPOSURES
In the past, many investors believed an active approach served as the best way to invest in niche markets such as emerging market debt (EMD). That belief has been based on a few assumptions, for example that indexed exposure is too expensive to be effectively implemented in emerging markets. Additionally, many investors view EMD as an inefficient market where active managers are needed to identify and extract value, and to avoid weak segments of the market.
The reality is different. EMD now offers much greater liquidity and diversity, and the majority of active managers fail to outperform their benchmarks over the longer term.
We analysed the active managers in the Morningstar database that track the JPM GBI-EM Global Diversified Index (GBI-EM) for the 2013 to 2018 period. The data compiled shows the majority of active managers have failed to outperform the index. 2017 was their best year – with 60% of active managers underperforming. In 2018, 97% of active managers underperformed the index.
While active managers have struggled to consistently deliver excess returns, indexed strategies have evolved and now possess sophisticated techniques capable of delivering the return of the benchmark in a cost-efficient manner.
FI ETFs OFFER INVESTORS GREATER DIVERSIFICATION AND LIQUIDITY AT LOWER COSTS
The rising popularity of fixed income ETFs should not come as any surprise to investors who have completed their due diligence on ETFs’ myriad benefits. Their ability to enhance both portfolio liquidity and diversity, on top of their lower cost structure, makes them highly attractive to a broad spectrum of market participants.
Visit www.abf-paif.com* for our latest insights and investment ideas for Asian fixed income.
* State Street Global Advisors commissioned Greenwich Associates to conduct a global study of 151 institutional investors and 36 intermediary distributors from Asia Pacific, Europe and the United States between October 2018 and March 2019.
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