Why Fixed Income Funds May Fall Short
[This article previously appeared on our sister site, IndexUniverse.eu.]
This year has seen increased demand for fixed income ETFs and record inflows into investment grade and high yield corporate bond products. However, some commentators have been critical about the transaction costs and tracking error associated with these products.
Tracking error measures the divergence of an ETF from its benchmark. But this can be hard to interpret and many observers look instead at the actual under- or outperformance of the fund versus its index. Tracking error is a good measure of the quality of a fund’s replication of the benchmark index.
But though they may not realise it, the amount that investors pay in management fees actually contributes towards a fund’s tracking error. There are also three other important factors that may impact on the tracking error.
The majority of fixed income ETFs replicate index performance by physically buying and selling index securities. However, it is not always feasible or cost effective for a fund manager to physically buy everything in an index. Instead the fund manager will buy enough holdings to faithfully represent the index. This is called sampling or optimisation, and is the most common method of physically replicating bond indices.
Sampling can cause the fund’s performance to veer significantly from the benchmark. In the fixed income market this risk is particularly relevant for corporate bonds, where the pricing has a volatile credit spread component that is driven by corporate news and ratings. Being under or overweight a distressed credit can have a big impact on the tracking error and for this reason it is rare to see aggressive sampling in corporate bond trackers.
With the synthetic replication that is frequently used by issuers in Europe, a fund sources the index performance using over-the-counter swaps, typically with an investment bank. Provided the swap is based on the same underlying benchmark as the ETF, the swap counterparty guarantees to deliver the index return to the fund.
Fixed income indices typically have a higher turnover than comparable equity benchmarks.
Much of the turnover exhibited in bond indices is intrinsic to the bond market itself. Most fixed income ETFs use benchmarks made up of bonds with a fixed maturity date and interest payment. As these fixed interest bonds get close to their scheduled maturity date they become less sensitive to interest rate changes and most benchmarks exclude bonds below a minimum maturity. The supply of new bonds can vary widely with market conditions but frequent borrowers typically issue bonds with a range of maturities in order to spread their capital repayments and to take maximum advantage of differing funding opportunities.
At each index rebalancing (usually monthly) new bond issues that meet the eligibility requirements enter the index and bonds below the minimum maturity leave. Corporate bond benchmarks also have rules based on credit ratings, which are also applied during rebalancing and these, particularly changes from investment grade to junk or vice versa, can have a major impact on index composition.
High index turnover is conventionally associated with high tracking error for a fund. As discussed in a recent IndexUniverse.eu article (What’s Inside Your Index), transaction costs are not fully reflected in indices and will therefore contribute to the fund’s tracking error. While some indices attempt to capture trading costs by taking into account the bid/offer spread on entry and exit from the index, others completely ignore costs. Slippage (the difference between the price used in the index and the price at which a fund can trade) also contributes to fund tracking error.
Pimco and Source launched a new ETF this week that attempts to deal with this issue by allowing the benchmark to hold bonds to maturity. The Pimco Short-Term High Yield Corporate Bond Index Source ETF (STHY) is based on the Bank of America Merrill Lynch 0-5 Year US High Yield Constrained Index. Instead of selling bonds prior to maturity and suffering transaction costs the index allows bonds to mature, when it receives maturing bonds’ principal and final coupon payment.
While the technicalities of index replication and the level of index turnover both influence tracking error, the biggest risk for a fund is in not being able to access all of the bonds included in the index.
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