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ETF Education

A Framework for Selecting Fixed Income ETFs

The rapid expansion of available ETFs has provided investors with more choice. Yet, at the same time, investors may find navigating the investment landscape more challenging This practical framework can help investors select the fixed income ETFs that best meet their needs, whether they’re seeking risk, yield or diversification.

Evaluate Your Investment Objectives

Does the ETF you’re considering align with your investment objectives?

Questions to ask, and why is this important

What is your risk investment objective and tolerance?

Understanding your objectives and risk tolerance for your fixed income investment is the most important element of investing. Is your style dynamic or buy and hold? The ETF should be as precise a match for your investment objectives as possible.

What is your investment horizon?

Are you investing strategically over the long term or tactically? Is your style dynamic or buy and hold? The transparency, tradeability and cost-efficiency* of ETFs may help strategic investors with a 5- or 10-year horizon who are cost and tracking conscious, as well as tactical investors with a 3-month horizon looking for easy and liquid access.

Is your portfolio precise or diversified?

Diversification across factors such as region, country, asset class and currency can help lower idiosyncratic risk and overall portfolio volatility. On the other hand, ETFs can also be a precision tool, giving investors the targeted exposure they want, or avoiding unwanted exposures.

Evaluate the Index

Does the index align with your portfolio?

Questions to ask, and why is this important

How does the ETF replicate the underlying index? Physically, optimisation/sample-based or synthetically?

The method may have implications for the ETF’s tracking error, cost and risk. The method of choice for many fixed income ETFs is an optimisation/sample-based approach to create a representative or optimised portfolio of securities that closely matches the characteristics of the underlying index.

How long has the index existed?

Even as new indices are constructed, the index family’s (e.g. Bloomberg, FTSE Russell, S&P Dow Jones Indices) tenure in the marketplace can indicate a measure of stability.

What is the index weighting methodology (e.g. market-capitalisation)?

Disparate index weighting methodologies can lead to differences in performance and risk/return characteristics among seemingly similar indices.

Does the index report holdings on a daily basis?

Transparent holdings data is key for understanding the benefits and risks in the underlying bonds. This data should be easily available on the index provider’s website.

How often is the index rebalanced?

Traditionally, fixed income indices rebalance monthly on the last business day of the month. It allows for concentrated trading at month end and includes new issues.

Do the index’s holdings overlap significantly with existing strategies in your portfolio?

Significant portfolio overlap can leave your portfolio over-exposed to various regions, issuers or durations. An index approach may ensure there is little or no overlap due to its transparent nature.

What are the index risks?

The main sources of risk associated with fixed income indices are: currency risk, interest rate risk, credit risk and liquidity risk.

Examine the ETF Issuer

Does the firm have a solid reputation in the ETF marketplace and the appropriate resources and skills in fixed income investing?

Questions to ask, and why is this important

How experienced is the ETF issuer in developing and managing fixed income ETFs?

Large, well-established firms with a long ETF history may have an advantage in this evolving marketplace.

What are the issuer’s total assets under management (AUM) in fixed income and total ETF AUM?

Total assets may indicate investment expertise and stability, while high ETF assets further illustrate a commitment to the ETF marketplace.

How broad is the issuer’s fixed income range?

A broad range should contain exposure to all the maturities and regions that you need in order to effectively manage the yield curve, credit, and sector allocations.

Does the issuer enjoy good relationships with index providers?

A trusted partnership between the index provider and the ETF issuer helps ensure the sustainability of products in the long run, and the ability to meet client needs for product support and new offerings.

Does the issuer provide valuable trading support?

In today’s dynamic ETF marketplace, expert trading support can positively impact your bottom line.

Does the issuer have a strong local and global presence?

Local investment teams and operations allows for specialism in each credit market, for example.

How does the fund provider communicate with investors?

For an investor to effectively manage their fixed income allocations, transparent communication from the ETF provider is indispensable. For example, we provide easy access for professional investors to speak directly to our Capital Markets Group, strategists and client services.

Consider the Total Cost

Does the ETF minimise expenses?

Questions to ask, and why is this important

What is the fund’s total expense ratio?

An ETF’s total cost of ownership often compares favourably to a mutual fund’s expense ratio. Aside from management fees and fund overhead costs, the total cost of gaining the exposure could include factors such as trading spreads or swing factors, brokerage, among others.

Does the investment process take into account the impact of rebalancing costs on the performance of the ETF?

The frequency of rebalancing can impact costs.

What is the average bid-ask spread?

A narrow bid-ask spread versus the underlying basket of securities’ bid-ask spread could indicate an opportunity to gain exposure at a lower cost.

What is the tracking error of the fund?

Returns can deviate somewhat from the index, but profound differences may be a red flag for poor management or excessive trading costs.

Gauge Liquidity

Can you trade when you want to?

Questions to ask, and why is this important

What is the best route to trade a fixed income ETF?

The trading route you take impacts your bottom line. A supportive ETF issuer will be able to help each professional investor assess the best route for their particular investment requirements. Our Capital Markets Group can help.

How does the ETF maintain liquidity?

Due to their unique creation/redemption process whereby Authorised Participants (APs) create and provide liquidity when it is needed, ETFs have potential liquidity that may not be evident from assessing trading volume.

Has liquidity been impacted due to market volatility?

Due to their unique in-kind creation/redemption process, an ETF’s liquidity actually reflects the liquidity of the underlying securities. Therefore, if the ETF holds thinly traded securities, APs may find it more difficult to source liquidity during times of market stress. Additionally, traded volume is not the only indicator of liquidity, and it is always advisable to contact the Capital Markets Group during these times.

Does trading activity cause dramatic price swings?

Large spreads between the bid and ask price often indicate an illiquid ETF, so you will want to study the spreads and market movements over time.

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