For ETFs, Fixed Income Matters More Than Smart Beta

December 21, 2016

Exchange-traded funds are transforming the asset management industry. Since the financial crisis, more than $1 trillion of net new money has flooded into ETFs, while essentially zero has trickled into mutual funds. Outside of the retirement space, the game is over; ETFs have won.

For much of the past two years, the biggest hype in the ETF space has surrounded “smart beta” and “factor” strategies. These are strategies that use academic research and quantitative analysis to tease out new approaches to the market, including many that (research shows) tend to beat the market over long periods of time.

Value funds are the oldest example, but new, hipper versions include low-volatility, high-quality and even multifactor approaches.

Where Smart Beta Goes From Here

We’ve been told that smart-beta assets will hit $2.4 trillion by 2025, and that they’re transforming investing as we know it. They are so hot right now that you’re starting to see articles about smart beta being “crowded,” with people talking about fading hot factors.

It’s all true. Smart beta is exposing a huge portion of the actively managed fund manager world as factor-chasing frauds, in much the way traditional indexing exposed so many active managers as overpriced benchmark huggers. But as critical as smart beta is to the future of ETFs, fixed income is even more important.

While ETFs offer an efficient vehicle for accessing smart-beta strategies, there is nothing about smart-beta strategies that says they can’t be made available in other formats (separately managed accounts, mutual funds, even active strategies).

With fixed income, however, ETFs are transformational. Particularly in today’s market, gaining fixed-income exposure through ETFs is an order-of-magnitude improvement over other avenues, and that advantage is only going to compound in the future.

As a result, and despite a potential bear market in returns, I think fixed-income ETFs will be the fastest-growing corner of the fixed-income market over the next three years. In fact, I think we’ll look back on 2017 as “the year of fixed-income ETFs.”

 

Why ETFs Matter For Fixed Income

To understand why ETFs matter so much in fixed income, you have to understand four things:

  • The actual fixed-income market is hosed
  • It’s getting worse
  • Fixed-income mutual funds have a fundamental flaw
  • It’s more than just mutual funds … ETFs are better almost everywhere

Let’s take those in order.

1) The Actual Fixed-Income Market Is Hosed

The problem with the underlying fixed-income market is that it’s built on 1800s-era technology.

When I ask you what the price of IBM’s stock is, you can look at the national best bid and offer (NBBO) and see a single midpoint price that everyone in the world agrees is “the price” for IBM’s stock. This NBBO reflects the considered opinions of the most sophisticated traders in the world, talking to each other through the most sophisticated technologies in the world.

When you want to buy that stock, your order is routed to multiple hyperconnected exchanges where high-frequency trading companies compete to fill that order. The competition is so fierce that people actually pay money to co-locate their servers next to exchanges and worry about absurd issues like cable parity.

When you go to trade a corporate bond, by contrast, there is no market; no agreed-upon price; no central exchange; and no concerns about cable parity. The prevailing way to trade a bond is to call up a bunch of people you know and ask them to name a price to buy it.

Literally.

The archaic nature of bond trading has three major impacts: First, spreads tend to be quite large, more on the order of 1% than 0.01% for high-yield bonds; second, different buyers get different prices—the price someone will quote PIMCO on $100 million in IBM bonds is different from the price they would quote you for $10,000; third, whatever liquidity there is vanishes in a crisis, as most people just don’t answer the phone when the bottom falls out.

 

2) It’s Getting Worse

The fixed-income market is getting worse. In the old days, banks used to buy and hold bonds in their own portfolios as a way to facilitate bond liquidity. If you wanted to sell $10 million of IBM bonds, banks were happy to buy them and hold them on their books in exchange for a modest fee.

But as this super-helpful TIAA-CREF white paper lays out, liquidity is crashing thanks to new regulations and capital concerns. Banks are unwilling to hold bonds, and therefore spreads are widening, and the number of players willing to make markets is thinning out.

It can now cost well over 1% to trade a high-yield corporate bond, and in times of crisis, it may be impossible to trade them at all.

3) Fixed-Income Mutual Funds Have A Fundamental Flaw

All this wouldn’t really matter except that most investors get their exposure through bond mutual funds, and a bond mutual fund is a terrible thing.

Every day, mutual funds must come up with a “net asset value” that reflects the underlying value of the securities they hold. Individual investors are guaranteed that they can buy or redeem shares of the mutual fund at that price at the end of the day.

In the case of an equity mutual fund, creating that NAV is easy: Funds simply add up the closing price for all the shares of IBM, GE, Cisco, etc., divide by the number of shares outstanding and move on.

In the case of bond mutual funds, it’s more difficult: Because most bonds don’t trade for days at a time, and there is no NBBO for bonds, bond mutual funds have to guess at the value of their holdings. They do this by hiring bond pricing services, which look at the price of similar bonds that have traded, run a few algorithms and come up with a hypothecated value for other bonds.

When It Doesn’t Work

This works for bond mutual funds … until it doesn’t.

The potential problems were revealed by the meltdown of Third Avenue. In that case, investors were redeeming shares of the Third Avenue Focused Credit mutual fund at a high rate. Unfortunately, the fund couldn’t sell its underlying bonds fast enough to meet those cash redemptions … at least not at the prices imagined by its hypothecated NAV.

So the fund sold all the liquid bonds it could until it was left with highly illiquid junk bonds, which, had they tried to sell, would have netted pennies on the hypothecated dollar. In essence, the NAV was wrong. Eventually, the fund gave up and closed, taking months to unwind.

Even when you don’t have a blowup of Third Avenue magnitude, bond mutual funds holders can face death by a thousand cuts. If a fund’s hypothecated NAV is $100, but it can only get $99/share when it sells its underlying bonds, it can be forced to sell more bonds than it should to meet redemptions in cash. When it does, shareholders who don’t sell subsidize those who do.

We know this is a problem because bond ETFs have proven the falseness of bond NAVs.

 

How Bond ETFs Are Different

Bond ETFs are different than bond mutual funds because individual investors don’t redeem shares of a bond ETF. Instead, if an individual investor wants to sell shares in an ETF, they simply do so on the open market at the prevailing market price, just as people do with individual stocks.

The job of redeeming bond ETFs falls to a group of institutional investors called authorized participants. Authorized participants make their living arbitraging the difference between the market price of an ETF and its stated net asset value.

For example, if an ETF’s NAV is $100/share but it’s only trading for $95/share, an authorized participant can step in and arbitrage the difference. They do this by buying the ETF on the open market, accumulating a set number of shares (let’s say 50,000) and turning them in to the ETF company.

In exchange, the ETF company gives them the stated NAV of the ETF, the same way mutual funds do with individual investors. But rather than paying out the NAV in cash, the ETF pays it out in-kind: In other words, it gives out $100 worth of the actual securities (stocks, bonds, whatever) that it owns.

Risk-Free Profit

In the right scenario, arbitraging this difference creates a risk-free profit for an AP: They buy the ETF for $95 on the open market, turn it in to the ETF issuer for $100 in underlying stocks/bonds, and sell those to lock in a profit.

The system works so well that liquid ETFs like the SPDR S&P 500 ETF TRUST (SPY) never trade more than 0.01-0.02% off of their hypothetical NAVs.

But in times of crisis, bond ETFs trade 3-5% or more off their NAVs. The reason is that the authorized participants don’t think the NAVs are real. The ETF might say it holds bonds worth $100/share, but the AP knows if it tried to sell them, it would be lucky to get $95/share. So they let the ETF trade to a discount before they act.

The beauty of the ETF system is that it protects buy-and-hold investors at the expense of people who panic and sell. In a traditional mutual fund, people who panic are able to redeem shares with a $100 NAV for $100 in cash, even if the mutual fund has to sell $105 worth of its bonds to pay that out. The people who continue to hold the fund subsidize the people who exit.

 

Panic-Selling Costs

With an ETF, people who panic only get $95/share, bearing the cost of panic-selling in an illiquid market.

This hasn’t been much of a problem in the bond mutual fund space over the years, because I think, largely, we’ve been in a bond bull market for 35 years. But if there are significant and sustained redemptions in the forthcoming bond bear market, it could be a real issue going forward.

ETFs solve this problem.

4) It’s More Than Just Mutual Funds

The amazing thing about bond ETFs, however, is that their impact is bigger than bond mutual funds. A primary driver of the growth of bond ETFs in 2016 was increasing usage by institutional investors, who flocked to them because, even for the largest institutions, ETFs can be the cheapest way to access certain parts of the market.

Institutional investors often forgo traditional index funds and instead hire an asset manager to track an index for them as a separately managed account. The fees on large-scale SMAs can be vanishingly small, down in the single basis points in terms of annual expenses.

But even the largest SMA in the corporate bond space would have to go into the market and acquire corporate bonds, and in doing so, would pay a spread approaching 1% for high-yield bond.

Alternatively, a manager could buy something like the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and pay a spread of 0.01%. HYG’s 0.50% fee might be high on a comparative basis, but if you save 2% trading in and out, that can cover the difference for a number of years.

What This Means For The Future Of ETFs

Fixed-income ETFs were late to the market, first appearing in 2002, nearly 10 years after the first equity ETF launched. Partially as a result, they are still a small fraction of the market: As of Nov. 30, 2016, fixed-income ETFs held $445 billion in assets in the U.S., compared with $2.5 trillion for ETFs as a whole.

But given the transformational nature of what fixed-income ETFs can do for the market, my guess is they’ll be the fastest-growing asset class in 2017 and beyond.

At the time of writing, the author held no positions in the securities mentioned. Matt Hougan is CEO of Inside ETFs. Join him to debate this and other topics at the 10th Annual Inside ETFs Conference, taking place Jan. 22-25 at the Diplomat Beach Resort in Hollywood, FL.

 

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