Uncertainty Surrounds Central Banks

Central banks have played a key role in bolstering stability in the aftermath of the worst global financial crisis since the Great Depression of the 1930s.

Extraordinary and unprecedented action has been taken in attempt to prop up economies, with interest rates held at record lows and rounds of quantitative easing (QE) to pump cash into the system.

Mario Draghi, president of the European Central Bank, famously said in 2012 that he would do “whatever it takes” to save the euro, while the appointment of Shinzo Abe the same year as Japan’s prime minister led to a huge QE programme under his policy dubbed “Abenomics.”

But investors have been left attempting to navigate financial markets in uncharted territory. Asset prices were artificially inflated in many cases as a result of QE, while low interest rates have also spurred investors to seek higher yielding assets.

Navigating Uncharted Waters With ETFs
With the prospect of divergent central banking policies, as the Fed looks to hike rates and Europe continues to ease monetary policy—cutting rates—investors are turning to ETFs as a way to hedge market movements that potentially arise as a result.

One of the main concerns is that a base rate increase will erode bond value. Although timing is uncertain, speculation is mounting that the US Federal Reserve will be first to raise rates as the economy strengthens, followed by the UK.

Alan Sippetts, investment director at Heartwood, said, “We think government bonds will underperform and deliver negative returns as rates start to normalise.”

Sensitive To Duration
Sippetts says he has employed ultra short duration ETFs to mitigate the risk while gaining exposure to credit.

“We’re using a number of specialist vehicles to express our views in fixed income, but our overarching theme is short duration, so we’re finding the iShares £ Ultrashort Bond UCITS ETF (ERNS) particularly useful for short dated sterling denominated investment grade debt,” he said.

Christopher Aldous, managing director of Charles Stanley Pan Asset, holds the SPDR Barclays 0-3 Year US Corporate Bond UCITS ETF (SUSD) and the iShares £ Corporate Bond 0-5yr UCITS ETF (IS15).

“The short end of the spectrum is an OK place to be; although not immune to rate rises, the capital impact is lower,” said Aldous.

Liquidity Concerns On Rate Hike
But other investors believe there are drawbacks in using traditional ETFs that are market capitalisation weighted to provide access to bond markets.

Caroline Shaw, head of fund and asset management at wealth manager Courtiers, said, “Fixed income is something we don’t like to gain exposure to through ETFs—the largest issuer is your biggest exposure.”

Liquidity in corporate bond markets is also a concern, in the event that interest rates increase. Drying up liquidity could be a problem if too many investors rush for the exit, and there are not enough buyers in the market.

“You can’t really enhance the liquidity compared to the underlying you’re exposed to just because you own an ETF – the liquidity you participate in is consistent with underlying assets,” said Sippetts.

Aldous is also “concerned” that so much money is crowding into the short duration corporate bond space. “If there is a sudden scare of default risk, there could be a big move out of corporates,” he said. “But otherwise I think these ETFs do a great job.”

Tempted To Short The Market?
Another way to play a potential rate rise is by employing short bond ETFs, to gain from any inverse movement in the underlying fixed income index once a rate rise occurs.

However, investors urge caution, noting the complexity and time frame for which these products are designed.

Sippetts said short and leveraged ETFs are “an absolute minefield,” while a number of constructs in this area are “not fit for purpose” due to the daily compounding of returns. This is fine for a day-trader, he said, but anyone investing for the longer term must understand returns are reset on a daily basis.

ETF Providers Latching On To Japan
Aside from the prospect of rising rates, QE has also had a substantial impact by buoying prices of risk assets over the past few years.

Abenomics and QE in Japan enticed many investors to buy equities in the view that the economy’s false dawn might be over and the sun would actually rise. A flurry of ETFs came to market after Abe’s radical measures, providing a liquid and efficient way to gain exposure. In Europe today there are around 40 ETFs providing exposure to the Nikkei, the Topix and MSCI Japan indexes in various currency lines.

Sippetts said that prior to Abe’s appointment, he was “cynical” about the progress that corporate Japan was making, but now Japan has elected a government with a clear mandate that includes reinvigorating the economy.

“Having had no Japan exposure, we have since had a positon there that’s been lucrative and profitable,” he said.

Beware FX Fluctuations
The Japanese yen’s volatile currency movements have warranted hedging—most clearly illustrated in 2013 when the stock market soared but the currency was decimated—and a number of ETFs are able to mitigate against the danger of FX swings.

Sippetts gains exposure through the iShares MSCI Japan GBP Hedged UCITS ETF (IJPH), as well as specialist active managers who he said can “participate in an improving market and hopefully give outperformance of an index.”

“We’re sensitive to the cost of paying for an active third party fund manager; ETFs are tax efficient and cost efficient,” he added.

With such diverging central banking policies, and with the abnormal market environment as a consequence, liquid and cost-efficient ETFs come into their own.

While the ETF toolbox must expand to provide a greater choice for hedging purposes, investors have an attractive selection ahead of looming rate rises, fluctuating currency movements and a likely continuation of abnormal economic policies.