Fixed-income ETFs in market to stay

It took them a while to arrive, but fixed-income exchange-traded funds are here to stay. At the start of 2007, Barclays Global Investors – the biggest ETF provider in the US – was the only investment management company with a bond ETF on offer. Today, however, there are almost two-dozen fixed-income ETFs on the market.

Last week State Street started trading five fixed-income ETFs, Vanguard introduced its line-up of bond ETFs in April and earlier this year, Barclays launched 10 new funds. Other players such as Bear Stearns and Ameristock have plans to launch bond ETFs later this year.

“The income space is ripe for ETF innovation,” says P. Michael Jones, chief investment officer at Wachovia Securities. “And it’s not just narrowed down to bonds. To the extent that we can create income-oriented solutions that are lower cost, they will take off like a rocket.”

There is no question that in recent years ETFs – baskets of securities that trade on an exchange like stocks – have been the investment phenomenon on Wall Street and Main Street alike.

According to figures from the Investment Company Institute, the industry body, more than 95 ETFs have launched already this year, and about 160 started last year. To put that in perspective, the number of ETF launches in 1996 was 17. As of the end of March, the assets contained within ETFs were more than $444.2bn.

The first ETFs – which were introduced by State Street in 1993 – mimicked big stock indices such as the Standard & Poor’s 500. They were similar to traditional index funds, but had lower fees and were more tax-efficient.

As they grew in popularity, providers began expanding beyond indexes to narrower segments of the market, allowing investors to back particular sectors, sub-sectors, geographic reg­ions or currencies.

Now the time has come for fund companies to expand their offerings to fixed income. Scott Ebner, senior vice-president of the American Stock Exchange’s ETF Marketplace, says that bond products represent a “large area of growth” for ETF providers. “There’s a real fixed-income push,” he says.

The question is: why were bond ETFs so late to the game?

The answer has to do with the lengthy ETF application process at the US Securities and Exchange Commission. Before a new ETF may begin trading, it must receive a stamp of approval – or what is known as an “exemptive order” – from the US regulator. Unlike applicants for many other types of exemptive relief, an ETF cannot start operating before the receipt of this order.

Historically, the application process has been tedious and time-consuming. The SEC reviews the submissions and then works with the investment management companies and their counsel to address any issues. This process can require several long rounds of comments and responses. Richard Morris, deputy general counsel at WisdomTree Investments, says: “It’s not uncommon for [this process] to take multiple years. The SEC needs to take its time to get its head around some of these issues.”

Regulatory obstacles aside, bond ETFs are simply a more complicated beast than stock ETFs, says Mike Woods, chief executive officer of XTF Advisors. “Fixed income is a lot harder to pull off with ETFs than equity. It’s a supply issue,” he says. “You have bonds that are maturing, and you have to replace them, so there are a lot of population challenges.”

But those problems are in the past, says Anthony Rochte, senior managing director of State Street Global Advisors. “There were some filing issues with the SEC, and it took some time to get exemptive relief, but I do think that with two major players coming to market this year, it will accelerate product innovation,” he says. “The core building blocks of fixed income are now in place.”

Noel Archard, head of product development for Barclays’ US iShares business, agrees: “There are 400 products in registration now [across the ETF spectrum], 50 per cent duplicate what’s already out there. But we’re also going to be seeing more beta building blocks that people are eager to get exposure to.”

The new crop of bond ETFs runs the spectrum of maturities. State Street’s Lehman 1-3 Month Treasury Bill index, for instance, includes all publicly issued zero-coupon US Treasury bills that have a remaining maturity of less than three months and more than one month, are rated investment- grade and have $250m or more of outstanding face value. Meanwhile, its Lehman Brothers Long US Treasury index includes securities that have a remaining maturity of 10 or more years.

Yet, investment strategies do make a difference. Take, for example, the Vanguard Total Bond Market index ETF and iShares Lehman Aggregate Bond fund, both of which track the $5.5bn Lehman Aggregate index. The iShares ETF, however, uses a sampling methodology and holds just 120 bonds. The Vanguard fund replicates the index in full and holds more than 2,500.

The discrepancy in the holdings can have an impact on an investment; a greater number of holdings diversifies risk, and a lower number often leads to a tracking error. “Barclays had a monopoly on the fixed-income market for a while, and Vanguard is doing a great job of taking it to the next level. It’s a snowball effect throughout the industry – someone comes along and says ‘we can do this better’,” Mr Woods says.

Like other stock ETFs, these new bond funds give investors relatively low fees and intra-day trading flexibility. Unlike mutual funds – which set a price for their shares once a day, after the market closes – ETFs are priced like stocks and traded throughout the day. This allows investors to dash in and out of the market while also using stop orders (to buy or sell when a specified price is reached) and limit orders (to buy or sell a stock at or close to a particular price).

Perhaps the greatest advantage of bond ETFs, according to Mr Rochte, is that they offer access to fixed income for investors who may have in the past had trouble buying individual bonds. “It’s no secret that it’s become more and more difficult for the individual investor to access individual bonds on his own,” he says. “This is an efficient way to express a view on any part of the fixed-income market.”

Another benefit of investing in bonds through an ETF rather than a mutual fund, according to Mr Woods, is that they are transparent. “If you’re in an ETF, you know exactly what bonds are in that fund and at what price. That’s an extremely significant difference.”

Fixed-income ETFs also represent a less expensive alternative to bond mutual funds, says Owen Concannon, an analyst at Financial Research Corporation, the Boston-based data company. Many of these new bond ETFs have expense ratios that hover around 20 basis points, while a typical bond fund has an average annual expense ratio of 1.09 per cent.

Mr Concannon says: “It’s certainly a cost-efficient way to invest in bonds. Fee-based advisors and professional investors who are comfortable with ETFs will certainly welcome more choice and more competition in cost.”

In spite of their low costs, transparency and easy accessibility, some have questioned whether or not bond ETFs have the same tax advantages as their equity equivalents.

One of the reasons equity-based ETFs are so trendy at the moment is that they rarely distribute capital gains, which gives them a tax benefit over stock mutual funds, which must distribute their capital gains and income each year.

In the fixed-income universe, most distributions are derived from income and not capital gains. This income is given out and taxed the same way regardless of whether it comes from a mutual fund or an ETF.

Another criticism is that index-tracking products – such as ETFs – are not necessarily considered the best way to access the bond market. Some industry observers claim that actively managed funds are a better way to approach investing in fixed income since there are active managers that have a solid record of beating the indexes.

“It’s an everlasting debate,” Mr Concannon says. “It’s all about what advisers are comfortable with, but I wouldn’t think it’s too much of an impediment. With indexing, you either buy into it, or you don’t.”

Mr Rochte says while the point may be valid, it is a question ultimately for an individual investor. “A better question might be: what is the right balance of passive and active in your portfolio?” he asks.

“In the fixed-income space, there are some areas that are more efficient, some that are less. You have to think about that when you are making your portfolio.”

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