Fiction #2: Fixed income ETFs are not sufficiently liquid, and investors can run into trouble when many try to redeem at the same time
The unique structure of a fixed income ETF — which packages a diversified portfolio of bonds into a single, tradeable equity — provides two sources of liquidity for investors. These two sources, ‘primary’, which can be accessed via an authorised participant and ‘secondary’, which can be accessed directly, define a fund’s overall liquidity profile.
Fiction #3: When using a fixed income ETF, the investor is overweight the most indebted — and therefore the riskiest — companies
Large issuers of debt are companies with substantial asset bases and revenue profiles. This provides the ability to pay and service the debt on the firm’s balance sheet. Focusing only on the amount of debt an issuer has in an index overlooks a few key variables.
Indices are rules based, focusing on diversification and liquidity for ensuring investability. As a result, not all of an issuer’s debt is included in an index, which paints an incomplete picture of the firm’s overall indebtedness. For instance, an issuer can have short term liabilities that do not qualify it for inclusion in an index, or debt financing secured in subordinated form, or financing denominated in a different currency
Additionally, an ETF's index construction inherently provides diversification benefits and often employs constituent capping to mitigate concentration risks.
Fiction #4: Fixed income ETFs underperform active managers when markets are volatile
We analysed five significant market events over the last 20 years, including the Global Financial Crisis, which represented periods of volatility or turbulence in the bond markets. The analysis focused on the performance of active managers within the Bloomberg Barclays Euro Aggregate Bond Total Return Index.
Our findings revealed that index-based fixed income exposures would actually have outperformed, on average, 77% of active managers.3
Fiction #5: Fixed income ETFs are only useful for the largest, most straightforward bond exposures, while for niche areas, active managers provide a better return
In the past, investors believed an active approach served as the best way to invest in niche areas such as emerging market debt. That belief has been based on a few assumptions, for example that indexed exposure is too expensive to be effectively implemented in emerging markets, and that emerging markets are inefficient – hence active managers are needed to identify and extract value.
The reality is different. Emerging market debt (EMD) now offers much greater liquidity and diversity, and our analysis suggests the majority of active managers fail to outperform their benchmarks over the longer term.
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-efficient4 manner. Further, an ETF’s diversification can help to mitigate political and sentiment driven events, which are difficult to predict.
Fiction #6: Index investing doesn’t work for bonds because there are too many bonds to index efficiently
Given the sheer number of bonds, it is generally not possible to hold every single one in an index. For example, the Bloomberg Barclays Euro Aggregate Index contains 5,026 different bonds.5
But an index investment manager’s objective is not to hold every bond in the index – it is to seek to track an index’s return with minimal tracking error. This means replicating the duration, curve, and issuer credit exposure of the index in a smaller sample.
Fiction #7: Many investors are not set up to trade fixed income ETFs — the process is difficult, and understanding ETF pricing and liquidity is challenging
Investors seeking to trade fixed income ETFs have straightforward ways to access fixed income ETFs: via an exchange or via over-the-counter (OTC). When considering which one to select, investors should primarily consider their trade size. As with single stock equities, larger trade sizes exceeding average daily volume should be handled with greater care and investors should work with a broker dealer or market maker OTC.