Traditional bond investors take a “buy and hold” approach, buying new bond issues when they come to the market and holding them until they mature. Small cap issues are hard to source as they quickly become locked up in such portfolios. Bonds that have been in the market for a long time also tend to suffer from this problem. Illiquid bonds often have high bid/offer spreads and poor pricing, but are still included in broad benchmarks for completeness. As ETFs depend on being fully tradeable, an ETF provider is unlikely to be able to include these issues in the fund portfolio.
Many fixed income ETFs use so-called tradeable indices to address this issue. Designed to deliver comparable returns to a broad benchmark but with a more efficient/smaller portfolio, tradeable indices utilise a sampling approach to reduce the benchmark to a small, often fixed, number of highly liquid bonds. The risk with these indices is that over time they may become unrepresentative of the broader market. A case in point is the iBoxx $ Liquid High Yield Index, which started life as the Goldman Sachs $ HYTop Index, a basket of 50 of the most liquid high yield bonds. By 2009 the dollar high yield market had doubled in size and Markit, the new owner of the index, changed the index rules to follow a more traditional large cap based approach.
Tradeable indices can also be too concentrated to support investment demand. If an index becomes too popular fund managers may struggle to source enough of each index bond to match index weights without moving the market. To counteract this, some fund managers use an oversampling approach where they match the underlying index exposure but spread it across more bonds. The iShares Markit iBoxx Euro Corporate Bond ETF (IBCX) is based on the Markit iBoxx Euro Liquid Corporate Bond Index, which comprises 40 bonds, but it uses between two and three times the number of holdings of the underlying index. Oversampling also carries the risk of introducing tracking error. Concentrated indices also tend to have a higher turnover than broad indices.
Tradeable indices are heavily used by providers of synthetic ETFs where index size and ease of replication is particularly important. In Europe Deutsche Bank, Amundi and Lyxor all offer synthetic ETFs benchmarked to tradeable versions of the Markit corporate bond index family, while iShares, ETFLab and UBS all provide physically-replicated ETFs based on the same family.
Some ETF providers, however, make a virtue out of using a broad benchmark. As well as offering ETFs based on tradeable indices, iShares also offers a parallel range of ETFs using broader-based traditional bond benchmarks from Barclays Capital.
Alex Claringbull, senior fixed income portfolio manager at BlackRock, parent company of iShares, says: “The first generation of fixed income ETFs were a product of their time, and a large number of providers tried to change investor perceptions about what they wanted, often because the products were unable to offer more flexibility. More recently providers have changed the way their products can be accessed and responded to investor demand for greater choice. We have the index tracking experience to offer well-known benchmarks in iShares format, for example, but there is room for both types of products, such as the iShares Euro Corporate Bond iBoxx Liquid ETF and the iShares Broad BarCap Euro Corporate Bond ETF, on the shelf.”
Another fund using a broad benchmark is the newly launched Pimco Source High Yield ETF (STHY) mentioned above. Its benchmark covers over 800 securities, from which Pimco select bonds using an internal rating system that attempts to avoid illiquid issues and issuers who are most at risk of default.
Where tracking error is concerned it seems that there are no silver bullets. While tradeable indices seem to offer a partial solution for corporate bond ETFs, they run the risk of becoming unrepresentative of the underlying market and can also suffer higher turnover as a result of concentration. Broader indices are more representative but are harder to replicate and rely more on the skills of a fund’s manager to keep tracking error to a minimum. It seems that there is no escape from the old adage of “know your index and know your manager”.