Are fixed income ETFs distorting the market? Are they difficult to trade and accurately price? Could they be more likely to underperform active managers in volatile markets?
This report identifies and analyses eight common misconceptions associated with fixed income ETFs, including their impact on the overall bond market, their performance compared to active managers (for mainstream and niche exposures) and their implicit overweight to the most indebted companies.
Fiction 1: The fixed income ETF market has become so large that it distorts the bond market.
Fact: Despite their rapid growth, fixed income ETFs still only represent 2% of the total investable fixed income universe and 5.6% of the US high yield market. Moreover, in some fixed income segments, ETFs are becoming an important source of additive liquidity to their respective markets.
Fiction 2: Fixed income ETFs are not sufficiently liquid, and investors can run into trouble when many try to redeem at the same time.
Fact: A fixed income ETF’s liquidity is at least as liquid as the underlying market that it tracks. The ability to invest in an ETF via the primary and/or secondary market can provide greater liquidity compared with alternative approaches to bond investing, such as index and actively managed mutual funds.
Fiction 3: When using a fixed income ETF, the investor is overweight the most indebted – and therefore the riskiest – companies.
Fact: The ability to issue debt is directly related to a company’s overall financial strength. An ETF’s index construction inherently provides diversification benefits and often employs a constituent capping to mitigate concentration risks.
Fiction 4: Fixed income ETFs underperform active managers when markets are volatile.
Fact: During seven systematically important volatile markets from the past 20 years, index-based fixed income exposures would actually have outperformed, on average, 73% of active managers.1
Fiction 5: Fixed income ETFs are only useful for the largest, most straightforward bond exposures. For niche areas, such as emerging market debt, active managers provide a better return.
Fact: A high percentage of active managers in the emerging market debt space have underperformed their benchmark each year since 2013. An ETF’s diversification can help to mitigate political and sentiment-driven events, which are difficult to predict.
Fiction 6: Index investing does not work for bonds because there are too many bonds to index efficiently.
Fact: An index investment manager’s objective is to seek to track an index’s return with minimal tracking error. The objective is not to hold every bond in the index.
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.
Fact: The complexity can depend on the needs of the investor, but there are a few straightforward ways to access fixed income ETFs.
Fiction 8: During the recent COVID-19 crisis, fixed income ETFs exaggerated the decline in the underlying bond market.
Fact: Market participants gravitated toward ETFs as price discovery and liquidity vehicles.
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