Adding value in fixed income ETFs
By Howard Chan & Fabrizio Palmucci – Today, over 40 per cent of assets in the European fixed income ETF universe are invested in funds that track sovereign bond indices, most of those being plain vanilla benchmarks. While this ratio is falling with the launch of new ETFs in asset classes like corporates, High Yield (HY) etc, there remain many opportunities to add value.
Source and PIMCO partnered to deliver better solutions compared to the current market offering. We believe that every sector within the fixed income universe needs to be tackled separately in order to craft a value-added solution. For example, in the cash and short-term markets, with accommodative monetary policies depressing money market yields, it is challenging to add value through passive replication. A manager that takes an intelligent approach, though, through duration management, credit selection and sector rotation, can generate returns in excess of traditional money market funds.
Since the launch of the PIMCO Source short-maturity ETF range (in EUR, USD, and GBP) the strategies have gathered over USD2.6billion in assets and are now the biggest actively managed fixed income ETFs in Europe (DB ETF research, 11 April 2013).
Other sectors require different approaches.
In Emerging Market (EM) local debt, traditional market capitalisation-weighted indices typically allocate more weight to countries which suffer from balance-sheet and growth headwinds, such as Eastern European nations. More importantly, these indices typically exclude some BRIC countries, like India and China, which accounted for over 50% of 2012 EM GDP (on a PPP-adjusted basis).
The PIMCO Emerging Advantage Local Currency Bond Index (Ticker: EMAD Index) seeks to represent the economic output of EM nations by weighting eligible countries by their share of world GDP, whilst also maintaining sufficient diversification. The index constituents include countries like the BRICs and Mexico, so as a whole the countries in the index account for over 70 per cent of GDP produced by the EM universe. This GDP approach offers a more forward-looking and representative exposure for investors.
In the high yield sector, the short-term segment has historically offered similar returns to broad HY with a lower volatility profile. However, delivering index returns may be a daunting task given that diversified indices like the BAML 0-5 Year US HY (Ticker: HUCD Index) includes 800 bonds, some being extremely illiquid.
Here, PIMCO, leveraging over 40 years of fixed income experience, seeks to optimise portfolio exposure based upon risk and liquidity factors to manage the tracking error between the fund and the benchmark. In addition, the portfolio replication process applies a fundamental filter to exclude “red light credit”: i.e. those issuers whose viability as a going concern is in question.
The above approaches highlight that fixed income ETFs have evolved from a plain vanilla instrument to offer more efficient exposure across a variety of market sectors. At the same time, the liquidity, transparency and ease of trade of ETF instruments remain a key advantage over mutual funds.