Four factors are driving future growth of fixed income ETFs

Nov 26th, 2019 | By | Category: Fixed Income

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By Matthew J. Bartolini, Head of SPDR Americas Research, State Street Global Advisors.

Matthew J Bartolini, Head of SPDR Americas Research

Matthew J Bartolini, Head of SPDR Americas Research.

Although the traditional allocation to bonds in a moderate portfolio is 40%, fixed income ETFs represent just 20% of the overall US-listed ETF industry.

Despite the smaller share, fixed income ETF assets under management have grown at a faster pace than equity ETFs, 78% versus 68% over the past three years.

That growth will likely accelerate due to four factors: Cost, Choice, Client Need, and Comfort.

Factor 1: Cost

Fees have been a main driver of buying behavior over the past three years. Sixty-three percent of the $977 billion invested in ETFs has been directed to low-cost core exposures.

Because cost can be relative to an asset class and specific to a subsector (e.g., a low-fee emerging market (EM) debt fund is more expensive than the low fee US Treasury fund, but it is still low fee relative to its peers), we examined flow patterns at the subsector level, based on Morningstar classifications, breaking each bond category into fee quartiles (Quartile 1 = low fee for its category, Quartile 4 = high fee for its category).

As shown below, over the past three years, $431 billion more flowed into the first quartile expense ratio funds in a given Morningstar Category (including ETFs and mutual funds) than into fourth quartile.

Source: SPDR ETFs.

First quartile fixed income mutual funds attracted $466 billion and ETFs $123 billion over the last three years.  While mutual funds took in more assets on a notional basis, fixed income mutual funds are five times larger than ETFs. Controlling for asset size, first quartile ETFs amassed a staggering 72% of start-of-period’s assets versus just 19% for mutual funds.

As shown below, fixed income ETFs have a lower median and average fee within each Morningstar bond subsector category. This is not just an index versus active phenomena, as the median active ETF charges 0.40% versus 0.68% for active mutual funds.

Source: SPDR ETFs.

Key takeaway: On a relative basis, low-fee fixed income ETFs had a stronger asset raise than mutual funds. That advantage is likely to continue based on ETFs’ fee and structural advantages (e.g., transparency and tax efficiency) versus mutual funds.

Factor 2: Choice

The significant expansion over the last decade of bond subsector strategies (e.g., EM debt, specific duration exposures) has created more opportunities to use ETFs to express a wider array of basic to sophisticated market viewpoints. As shown below, in 2005, there were just six fixed income ETFs. Now, there are nearly 500 funds that can be beneficial to both tactical and strategic asset allocations given both the broader coverage and the wider dispersion of returns and risk.

Source: SPDR ETFs.

The benefits of greater ETF choice can be seen by examining the risk and return metrics over the past three years of the six original ETFs versus today’s full list of ETFs. As shown below, the original six have a dispersion of returns of just 3.37%, and the difference across the standard deviation of monthly returns was just 11.01% over the period.

However, the dispersion of returns for today’s full list of funds is 24.79%.

Source: SPDR ETFs.

Additionally, investors can choose from smart beta funds and more than 100 active funds with more than $70 billion of assets (48 funds have at least a three-year track record). Greater fund choice will continue to drive adoption, especially as these strategies build longer track records.

Key takeaway: Investors are leveraging the operational benefits of ETFs (lower fees, transparency, and taxes) across a multitude of bond subsectors to construct and tailor a wide range of fixed income portfolios. That should continue to propel future growth of fixed income ETFs.

Factor 3: Client need

Two emerging investor trends are worth highlighting. The first is an aging population’s need for stable income. As shown below, the percentage of the US population over the age of 65 has steadily increased every year for fourteen years and is projected to reach 20% by 2028, per the US Census Bureau. Additionally, 21% of the nation currently receives Social Security benefits. Both trends are expected to keep increasing.

Source: SPDR ETFs.

So it’s not surprising that of the US-listed Retirement Mutual Funds, the years 2025 and 2030, have the greatest assets. Those mixes generally have a bond allocation between 30 and 40%, depending on the plan sponsor. As shown below, these funds have received some of the highest flow totals over the past three years. Only the 2035 portfolio received more–an allocation that typically has 25 to 30% in bonds.

Source: SPDR ETFs.

Key takeaway: Using retirement target funds as a proxy for the asset allocation mix of an increasing share of our aging population, the need for income will increase and spur investment in bond-related strategies.

Interestingly, we have started to see Retirement mutual funds, as well as other asset allocation strategy types, hold ETFs rather than other mutual funds due to ETFs’ lower total cost of ownership (TCO) and ability to offset fees by lending out the underlying ETFs –something that cannot be done with a mutual fund.

The other important trend is an uptick in adoption of ETFs by insurance companies. Through the first half of 2019, insurance companies traded $16.7 billion of fixed income ETFs – essentially the same amount traded for all 2018, with assets jumping by 34%, per S&P Global Market Intelligence Data, to nearly $10 billion in aggregate.

This increase was driven by regulation changes centered on creating the bond-like statutory accounting treatments via NAIC Designations with a process known as systemic valuation leading to the “bondification” of ETFs. Now, rather than holding 1,000 individual bond line items, an insurer can hold a bond ETF and apply the same “bond math” from a capital perspective. As a result, fixed income ETFs create operational efficiencies for large and mega insurers and enable small- and mid-sized insurers to gain economies of scale when building out portfolios to bank policyholder liabilities and surplus exposures.

Key takeaway: Regulatory changes have encouraged insurance companies to join pension funds, endowments and other institutional investors who use fixed income ETFs for tactical and strategic investment strategies – adding a new type of client to propel growth in fixed income ETFs.

Factor 4: Comfort

Given the first fixed income ETF was launched in 2002, the fixed income ETF’s wrapper and operational workflow has been tested through numerous market events and has consistently enabled investors to express market views with efficiency, flexibility, liquidity–and confidence.

Still, myths persist, among them that fixed income ETFs may not be sufficiently liquid during market downturns or that growing AUM will impair price discovery. However, as we have seen in recent years, trading volume on fixed income ETFs has increased during the most volatile periods. And fixed income ETFs still only represent a small portion of overall investable assets, making up just 2% of the Bloomberg Barclays Multiverse Index total market capitalization.

Source: SPDR ETFs.

We have spent a lot of time de-bunking additional ETF myths, such as:

  • Index investing is distorting the bond market
  • High yield ETFs are bad for the market, part one and two
  • Index funds are overweight the most indebted firms

Key takeaway: With more identifiable periods to bust ETF myths, investors will become even more comfortable adopting ETFs.

The future for fixed income ETFs

Fixed income ETFs allow investors to evolve their bond portfolio and the four C factors will act as tailwinds for increased investment. To understand the potential asset size, we extrapolated the prior 12-, 24- and 36-month monthly growth rates to today’s asset base. Growth rates are calculated as the monthly flow totals as a percent of start-of-month assets. For each time horizon lookback period, the median, average, 80th percentile, and 20th percentile growth rate was calculated. The average of all those glide paths (12 in total: 4 metrics times 3 horizon lookbacks) was then used to create the ensemble asset projection shown below.

Source: SPDR ETFs.

Market movement can also be applied to the flow generated average growth. Over the past five years market move has been an average of $1 billion a year–or 0.28% of assets–and an average of $7 billion–or 1% of assets–over the last three years as declining bond rates as of late have led to sizable price appreciation. Add the average between those two (+0.68% a year, 0.06% a month) to the monthly ensemble average (+1.9%) and US-listed fixed income assets could reach $1.1 trillion by the end of 2020, $1.3 trillion by 2021, and $1.7 trillion by 2022.

With the four C factors continuing to drive adoption, it’s likely we will reach those milestones.

(The views expressed here are those of the authors and do not necessarily reflect those of ETF Strategy.)

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