Equities

Do ETFs deliver on all their promises? Three questions to ask your provider

  • 10 January 2018
  • 5min read

In an environment where investor appetite for cost-effective access to financial markets shows no sign of abating, it’s easy to see why Exchange Traded Funds (ETF) have become the ‘go-to’ investment vehicle. In fixed income markets, as a short term tactical asset allocator ETFs provide an efficient and liquid wrapper. However, for investors looking for exposure to long term credit market returns, here are three questions you should ask of your fixed income ETF.

1 Is there a trade-off between high liquidity and balanced market exposure?

The size and scale required to maintain appropriate liquidity levels essential to ETF strategies means that they tend to gravitate towards the largest, most liquid issuers in the universe. In this respect ETFs can end up mirroring market-cap indices. The concerns associated with fixed income indices are well documented. In short, overall index exposure tends to be concentrated in the most indebted sections of the market. For example the top 10 issuers in the ICE BofA Global Corporate Bond index make up 25% of the total index.  Concentrating exposure in a few large names leaves investors exposed to systemic risk and investment bubbles. You should ask how your ETF manages over-concentration risk, to regions, sectors and issuers.

2 Do ETFs provide a genuine low-cost solution?

ETFs that track an index are forced to follow illogical index rules and are consequently subject to unnecessary transaction costs. These include automatic selling on downgrades and or selling when a bond comes within 12 months of maturity. Forced selling not only creates additional turnover costs but in the case of downgraded bonds, trades are made at precisely the worst moment. Generally, a bond’s price will fall as soon as it drops out of an index, but thereafter it tends to rise as the investor base shifts from investment grade to those investing in high yield bonds. Barclay’s research suggests that forced-selling due to downgrades costs on average 25bps1 of performance per year. You should ask whether your ETF is delivering sub-optimal performance through unnecessary transaction costs.

3 Do ETFs deliver long-term, compounded market returns?

General practice among fixed income ETFs is to distribute income from coupon payments. While this may provide an income stream in the short term, it does mean that ETF investors are missing out on the significant compounding benefits generated from re-investing income. You should ask whether your ETF is re-investing income to produce long-term compounded market returns. Is there a low-cost solution that has the potential to avoid these pitfalls? Buy and Maintain strategies focus on conservatively constructed portfolios that are designed to mitigate downside risk by diversifying across regions, sectors and issuers. Using a distinct, ‘active’ portfolio construction process, constantly monitoring the portfolio for credit quality and reinvesting where there is current value, investors can potentially gain efficient exposure to long term credit market returns, at similar fees to passive strategies. Investments involve risks, including the loss of capital.

  • Source: Barclays research as at January 2017 based on the US Corp IG Index, January 1990 – March 2016

    Not for Retail distribution:

    This document is intended exclusively for Professional, Institutional, Qualified or Wholesale Clients / Investors only, as defined by applicable local laws and regulation. Circulation must be restricted accordingly.

    This document is for informational purposes only and does not constitute investment research or financial analysis relating to transactions in financial instruments as per MIF Directive (2014/65/EU), nor does it constitute on the part of AXA Investment Managers or its affiliated companies an offer to buy or sell any investments, products or services, and should not be considered as solicitation or investment, legal or tax advice, a recommendation for an investment strategy or a personalized recommendation to buy or sell securities.

    It has been established on the basis of data, projections, forecasts, anticipations and hypothesis which are subjective. Its analysis and conclusions are the expression of an opinion, based on available data at a specific date.

    All information in this document is established on data made public by official providers of economic and market statistics. AXA Investment Managers disclaims any and all liability relating to a decision based on or for reliance on this document. All exhibits included in this document, unless stated otherwise, are as of the publication date of this document. Furthermore, due to the subjective nature of these opinions and analysis, these data, projections, forecasts, anticipations, hypothesis, etc. are not necessary used or followed by AXA IM’s portfolio management teams or its affiliates, who may act based on their own opinions. Any reproduction of this information, in whole or in part is, unless otherwise authorised by AXA IM, prohibited.

    Issued in the UK by AXA Investment Managers UK Limited, which is authorised and regulated by the Financial Conduct Authority in the UK. Registered in England and Wales, No: 01431068. Registered Office: 22 Bishopsgate, London, EC2N 4BQ. In other jurisdictions, this document is issued by AXA Investment Managers SA’s affiliates in those countries.