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Blogs - The Product Guru
New Wave of Fixed-Income ETFs Brings Fresh Possibilities for Clients
Bank Investment Consultant
Thursday, March 17, 2011
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Nearly every day, I get a notice touting the launch of some new ETF. And at this point, most of them represent some fringe aspect of the investment world. Small-cap stocks from one certain country in the Middle East, say, or a fund from Africa that deals with water infrastructure. Sometimes, they are sliced so thinly that there are just a handful of companies in the underlying index. Useful perhaps, but probably only for a limited audience.

But for the major ETF issuers, it does make some sense. The easy ETFs—the ones based on the S&P 500, for example—have been done. The low-hanging fruit is gone. But now, we may be on the cusp of a whole new area: fixed-income ETFs. This was the subject of an interesting report recently from research firm Aite Group.

The ETF structure clearly has appealed to investors. In the past 10 years, total ETF assets have increased from less than $100 billion to nearly $1 trillion today. But the majority of that attention is focused on equities. The potential in fixed-income has barely been tapped.

To be sure, fixed-income ETFs have seen some growth over the past few years. From 2008 to 2010, they have tripled to become 15% of the total ETF universe, according John Jay, the Aite senior analyst who wrote the report. But as Jay noted, the fixed-income universe is bigger than equities, giving these ETFs a lot of room to grow further.

In addition to the sheer size of the bond world, there are also more varied ways to slice and dice it into ETFs. With equities, there are small-caps and large, growth and value, sectors and countries. But with fixed-income, there is the possibility of creating ETFs not just by categories like munis or corporates, but also by other bond features like maturities, coupons or where the bonds sit in the capital structure. If an investor wanted an ETF that represented investment-grade bonds with three-year maturities, for example, he’ll be able to find it, Jay says.

Jay also notes that the ETF structure would allow for more esoteric investments. If an investor felt like adding a credit spread element to his portfolio, there will be ETFs available to reflect that sentiment. An investor won’t need to buy corporate bonds long and then also short Treasuries. That strategy will be contained in one ETF.

Jay thinks this will be a major draw for investors in future years as people get more comfortable with it. He notes that equity ETFs took a few years to really catch on, and now they’re a major force. He sees this same dynamic playing out with fixed-income ETFs

I’m not so sure I agree that the demand for the complex variety will be so strong. Even in equity ETFs, for all the fringe possibilities available, most investor attention is focused on the major indexes like the S&P 500.

But even so, if fixed-income ETFs follow a similar pattern as equity ETFs, with investors focused on major indexes and other smaller ETFs coming available for the few investors who really want them, that could parlay into a huge surge of new products on the market.

And if your clients are among those who want the complex variety, it will be easy to get them. You won’t have to buy long in one area and short in another. You’ll just need to buy the right ETF. But where you will have a higher bar is in the discussion with clients: being able to have the right conversations with the right clients. And being able to help them determine how these investments would best fit in their portfolios.

And who knows, if Jay is right, and the complex ones catch on, then a few years down the road, some reporter will be receiving four or five emails a week on the latest and greatest fixed-income ETF.

 

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