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March 13, 2017

Monday Morning Memo: Are bond ETFs a driver of growth or the next troublemaker for the ETF industry?

by Detlef Glow.

Bonds and bond funds, despite the low-interest-rate environment, are in general one of the preferred asset types of European investors. Therefore, it is not surprising that promoters of exchange-traded funds (ETFs) also try to get their share of this asset’s growth, which also explains the growing number of bond ETFs in the European market.

So far there is nothing wrong with this strategy, since there is no reason why ETF promoters in Europe should not launch bond products. My conversations with European ETF promoters echo the general picture in the European fund market; promoters say they launch those products because of client demand. That this demand is real is shown in the net inflows into bond funds over the last 15 month. On the other hand, I have heard from a number of asset managers that they use bond ETFs as proxies for single bonds, since these are sometimes hard to buy in the quantity needed by investors or the research efforts to find the right bonds are too demanding for investors. In this regard it is not surprising that some investors say they appreciate the efforts of ETF promoters to expand their product offerings.

Despite these obviously healthy developments, it seems there is something going wrong within the ETF market. Market observers are stressing the topic of missing liquidity in some parts of the bond market. In the past this point of criticism was answered by ETF promoters saying that an ETF can’t be more liquid than the underlying assets and that ETFs in general help to increase the liquidity of the underlying market segments.

Both points are right in general, but the details show that fund managers can’t buy a bond that is a constituent of an index if it is not available, try as they may. Therefore, they are not increasing liquidity in the respective bonds at all.

The fact that not all bonds that are constituents of an index are available in the markets (either in general or in the appropriate quantities), especially in niche market segments, puts a burden on promoters of bond ETFs. One solution for this problem is to use a modern portfolio management technique called sampling. This statistical method allows the portfolio manager to replicate the risk/return profile of an index without buying all the names on the constituent list by using the available securities with a different portfolio weighting than they have in the index.

However, investors’ use of bond ETFs as proxies for single bonds may lead to raised eyebrows. Even though it is understandable that they would do so for corporate bonds or emerging-market high-yield bonds, this strategy is in some cases also used for U.S. Treasuries and Eurozone government bonds. While ETF promoters appreciate this usage for bond ETFs, since they enjoy the inflows into their products, it leads to some risk for the overall industry. Nobody knows what might happen if several large investors simultaneously try to redeem their shares in an ETF that invests in a niche market; that may lead to a drop in prices and/or the closure of a fund if the promoter is unable to fulfill the cash requirements of the redemptions in a timely fashion. Even though ETFs, with regard to redemptions, are in general more flexible than mutual funds, investors expect to have their cash back right after they sell their shares and would therefore be disappointed if this didn’t happen.

For these reasons investors and market observers should continually monitor trends in the European ETF segment to avoid any surprises with regard to corporate actions such as closure of funds.

The views expressed are the views of the author, not necessarily those of Lipper.


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