Faced with some of the most challenging conditions ever seen in global bond markets, fixed income managers are looking for new ways to make money and manage risk. In that context, the emerging role for exchange-traded funds within institutional portfolios was explored at a recent roundtable, proudly hosted by Investment Magazine and sponsored by BlackRock.
Traditional bond-buying strategies are not working in the current low-growth, low-yield environment. Many investors are finding it challenging to generate short-term returns from bond markets while maintaining an acceptable level of risk – even if for the most part bond and equity markets remain negatively correlated over the longer term. In the hunt for new sources of returns, asset owners are grappling with how to access niche corners of the fixed income market, while maintaining adequate portfolio liquidity.
In the United States, this has already led to a strong uptick in the use of exchange-traded funds (ETFs) by institutional asset owners. In Australia, ETFs, a popular vehicle for retail investors, are still mostly eschewed by institutions.
“Things are much better in Australia than most parts of the world, but generally low yields are becoming a global challenge for investors. This makes it difficult to construct fixed income portfolios that can deliver positive long-term returns, especially in terms of inflation-adjusted returns,” BlackRock head of fixed income iShares strategy Matthew Tucker said.
The backdrop for fixed income investors is only set to become more complicated as interest rates normalise.
Australian asset owners have lagged their US counterparts in adopting ETFs as a portfolio tool, although the attitudes of local institutional investors are already starting to change, as indicated by the fact that one recently traded $45 million through a BlackRock fixed income ETF, Tucker said.
A fixed income ETF pioneer
Tucker, who is based in San Francisco, has been with BlackRock for more than 20 years and was the creator of the world’s first fixed income ETF in 2002. That and other early products were designed with retail investors in mind and Tucker admits he never anticipated they would become so sought after by institutional clients.
Then the global financial crisis changed everything. The collapse of a number of big institutions in the US left investors facing an uncertain future and in need of new ways to manage risk.
“Suddenly, in the over-the-counter bond market, liquidity became a question. And a lot of folks said, ‘Hey wait a minute. If I can’t trade bonds the way I used to, what else can I use? There’s this thing called an ETF, maybe I can trade that to get exposure to corporate bonds or treasuries?’,” Tucker said.
“That actually was the awakening moment for institutions to realise that the ETF, although it sits on the exchange, is actually a complement to over-the-counter bond liquidity. And we’ve seen institutional usage grow steadily over the years since then.”
Frontier Advisors head of debt research, Andrew Kemp, who advises some of Australia’s largest super funds, said one of the main reasons so few local institutions use fixed income ETFs is because they consider the fees on them relatively high.
“The fee structures that some institutions are getting on passive investments are in many cases a lot lower than ETFs at this stage. So, I think [managers] prefer to stick with individual mandates, where they’ve got a bit more control,” Kemp said.
But things are changing. Frontier has begun to research fixed income ETFs and some of its super fund clients are considering how these might fit within their portfolio. One tactic increasingly popular among US-based institutions is to use ETFs to tap liquidity and get in and out of mandates quickly.
Bank of America Merrill Lynch head of Australian asset owner coverage, Phil Pineo, said his team has used ETFs to help clients get tactical exposures to a range of fixed income markets, including US high yield, and emerging market credit. The advantage of ETFs is that they let investors be nimble with getting in and out of the market quickly and transparently, which is especially effective for liquidity sensitive clients, he said.
“We feel they [ETFs] are one good tool to add on top of manager selection.”
Another way US institutional investors are increasingly using ETFs is as a transition-management tool that allows them to stay in the market while in the process of moving a mandate from one manager to another.
Citibank Asia-Pacific head of transition management, Michael Jackett-Simpson, is starting to see this trend catch on among local asset owners.
“There have been cases where a fund manager has had some staff turnover and investors have wanted to de-risk the situation but they don’t know where they want to go yet, and it could take a few months to get their mandate ready,” Jackett-Simpson explained. “You can potentially use an ETF for that period of time.”
Christian Super, a $2 billion faith-based superannuation fund, is one example of a local asset owner that uses fixed income ETFs in this way.
“We are using ETFs much more for transition management,” said Christian Super senior portfolio manager Edwin Lo.
Mine Wealth + Wellbeing chief investment officer David Bell revealed that while the $10 billion super fund for the coal industry does not use fixed income ETFs, he was interested in exploring their potential as a transition-management tool.
“If you were using external funds and an event happened and you had to get out of that manager but maintain exposure to the market, then that’s where an ETF might have a role,” Bell said.
Roundtable participants from larger asset owners were less inclined to want to consider using ETFs as a transition-management strategy.
“We are focused on generating active returns,” Victorian Funds Management Corporation senior portfolio manager Nick Tribe said. “And given the nature of our organisation, we have quite a strong handle on cash flows, so from a liquidity perspective we’re reasonably well placed.” State-owned asset manager VFMC has roughly $52 billion in funds under management.
Avant Mutual Group chief investment officer John Lucey said the medical indemnity fund preferred to combine derivatives overlays with active manager selection to manage transition risks.
Another advantage for institutional investors to holding a small allocation to ETFs is the potential to make revenue from lending them out to short sellers, Tucker said.
“In the US, we actually see some investors who will use the ETF as a more strategic long-term holding, because the lending revenue they can pick up can be attractive.”
And while fixed income ETFs are traditionally associated with passive investment strategies, this is changing.
“There is a global trend that the strategies inside ETFs are not only traditional market cap-weighted indices,” Tucker said. “What’s inside the wrapper could be an index fund, an active fund, or a smart beta fund.”
BlackRock sees the potential for a big increase in inflation within the US and globally over the next few years, and is seeing rising demand for inflation-linked products.
BlackRock is increasingly using ETFs within its own active portfolios, not to hold large amounts of capital for long periods, but as a tool that allows the firm’s portfolio managers to tap liquidity and access new market niches in an inexpensive and efficient manner.
“One of the most common ways we use ETFs inside our portfolios is as a tool to put new inflows of cash to work. It’s a way to get the cash working while we find the individual bonds we want to invest in,” Tucker said. “The multi-sector guys use [ETFs] as a way to get exposure to asset classes that they don’t already hold. If they want to move into emerging markets on a short-term basis, the ETF is an efficient way to get in quickly and capture the market premium they are after.”
A tool for active managers
BlackRock Australia multi-asset portfolio manager Ron Montgomery said his team uses ETFs on a “horses for courses” basis within active portfolios.
“Where we’ve used them in the past has been where we’ve targeted an asset class that we think has good return expectations, but we haven’t found an active manager that we thought could add value over the long term and ETFs have stacked up well as compared to doing a derivative replication,” he said.
BlackRock is the world’s largest funds manager, with $US5.4 trillion ($7.4 trillion) under management, including $US1.4 trillion in iShares ETFs.
Russell Investments is a smaller firm that, like BlackRock, both sells fixed income ETFs and uses them as a tool within their actively managed portfolios.
“We’re using ETFs as a couple of per cent of the total portfolio, as a buffer,” Russell Investments Australia senior portfolio manager Clive Smith said. “The key role of ETFs within our funds is really as a source of being able to put cash to work very quickly.”
An added advantage of holding a small portion of the fixed income funds in ETFs is that in the event of another crisis, these products would likely be much more liquid than the secondary bond market, Smith said.
He said Australian institutions allocating a significant portion of their capital via ETFs was unlikely to become a trend.
“As an institutional investor, the fees on ETFs don’t necessarily stack up versus what you can get with a specialised mandate. However, as a short-term trading and liquidity tool, they make sense.”
BlackRock’s Tucker believes that with increased investor education, ETFs will play a greater role in Australian institutional portfolios in the future. Although he agreed that, initially at least, the products would predominantly be attractive for specialised roles, “as an exposure vehicle or financial instrument”.
He also predicted a rise in the use of ETFs for these reasons by fixed income fund managers. Although, none of the fixed income managers who participated in the roundtable anticipated this forming part of their strategy in the foreseeable future.
The touted benefits of ETFs, such as ease of access and added liquidity, are not considerations for IFM’s portfolio requirements, she said.
“Our portfolio has some inbuilt liquidity in terms of staggered duration, but it also comes back to [the fact that we are] transparent with our investors about what we do and manage their expectations.”
Bentham Asset Management senior portfolio specialist Daniel Conti saw no advantage to using ETFs instead of derivatives to manage cash and tactical allocations.
Perpetual Investments credit and fixed income specialist Ron Mehmet is another manager who preferred to use futures and derivatives over ETFs.
However, he suggested that the implementation of the Australian Securities and Investments Commission’s regulatory guidance note 97 later this year could give a boost to ETF providers. The incoming rule change will require superannuation and managed fund providers to disclose more of the indirect costs associated with off-market investments, meaning derivatives may appear more expensive.
“With RG 97, [for] anything that’s on an exchange, you don’t have to include the costs in the PDS [product disclosure statement], which is a positive for ETFs and other exchange-traded instruments,” Mehmet said.
Montgomery said BlackRock’s ETFs offer excellent transparency to investors, who can review iShares’ website for a full list of the underlying holdings in each product.
A macro trend affecting fixed income managers globally is the ageing population in rich Western economies, such as the US, the UK, Canada, European nations and Australia.
“As demographics get older, fixed income managers are under more pressure to generate retirement income. This challenge is also an opportunity because it means more money is going to come our way,” Tucker says.
Increased flows to fixed income mandates could lead to more of that capital being deployed via fixed income ETFs, leading Tucker to be bullish in his predictions for the size of the global market, which is currently valued at roughly $US600 billion.
“There’s no reason it can’t be double, triple, quadruple that size in the next couple of years. Because it’s helping solve an investment problem, and helping to address a gap and a need in investor portfolios.”
And as fixed income ETFs become more popular with local retail investors, this will only increase their appeal to the nation’s super funds and other big institutional investors, by creating a deeper and more liquid market.