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Bond ETFs: The Case For Indexing

In an environment of low yields and jittery stock markets, where do you hunt for long-term, low-cost investment strategies that offer liquidity, balanced risk and diversification? The solution, for an increasing number of investors, is fixed-income ETFs.

In the 10 years through June 2019, the value of bond-ETF assets grew from USD172 billion to USD1,018 billion1. While passive equity investment has gathered strength during that period, investors are realising that indexing works just as well in fixed income.

In fact, with 70 percent of the 350 US-listed bond ETFs now following an index strategy2, it’s not a stretch to say that passive bond funds are the future of fixed-income portfolio construction.

Why fixed-income ETFs?

To understand this trend, it’s useful to look at the fundamental benefits of investing in fixed-income ETFs. 

Fixed-income ETFs have been described as “a bond investment living in an equity world”, for several reasons. The cost benefits of ETFs are well-established, but it’s worth reiterating that in a low-yield world, where returns that are already dwindling can be rendered negligible by the total cost of ownership (fees, bid-ask spreads, commissions, etc), low-cost investing matters now more than ever.

In the bond ETF universe, about 80 percent of trading activity takes place in the secondary market3, meaning investors can “cross” their trades without incurring the costs of trading the underlying bonds, resulting in substantial transaction cost savings. During times of market stress, as we saw in the past few years such as the US taper tantrum in 2013/2014, or the sell-off in February last year, secondary-market trading delivers enormous benefits in providing liquidity.

Bond ETF investors may also derive savings from scale. For example, as fixed-income assets managed by Vanguard in the US grew from less than USD200m early in the millennium to more than USD1,100bn in 2018, its asset-weighted average fund charges have dwindled to just 0.08 percent.

Larger scale, lower cost over time 

The second major benefit is transparency. Compared with the world of stocks, the bond market is relatively opaque. Bond trading, particularly corporate bonds, trade via a fragmented dealer network, trade reporting occurs with a delay, and many bond issues rarely trade at all. This makes pricing difficult.

Bond ETFs, conversely, trade in the transparent and centralized equity ecosystem. This not only provides a level of connectivity that a dealer network cannot, but it means live quotes can be generated for a portfolio of corporate bonds that themselves don’t trade very often. Just like their equity counterparts, fixed-income ETFs also provide the opportunity for low-cost, liquid, and more reliable market exposure.

How does bond indexing work?

While in equity investing there is a higher feasibility in setting up a fund to fully replicate an index, bond indexing is somewhat more complex. For instance, what if a benchmark includes a bond that rarely trades, or one that’s already been fully bought by a pension fund?

Bond ETF managers employ a technique called optimisation, or sampling, to track bond indices. At Vanguard, portfolio managers first identify factors that drive benchmark performance – duration, sector exposures, credit-quality bucket exposure, maturity bucket exposure, issuer, etc. – then build a portfolio that mirrors the weights of those exposures, even if the composition doesn’t exactly match.

In an ideal world, a fund would hold all the issues in the same weights as the benchmark, but often that just isn’t manageable, so a lot of expertise and experience is required to track bond indexes as tightly as possible.

High-cost versus low-cost

What Vanguard offers investors is more than 40 years of fixed-income indexing expertise at low costs. Ultimately, costs are central to performance. Research shows that higher costs increase the odds and magnitude of underperformance, whether from passive or active management, and as that cost hurdle builds over time, underperformance becomes increasingly likely4.

Source: Vanguard

While bond ETFs have gained traction, some investors are drawn to active management in the belief that it increases their chance to outperform the market. In certain market conditions, active management has historically paid off. But investors need to be able to decompose returns and carry out effective performance attribution to ensure they are getting what they pay for.

With average expense ratio of around 0.1 percent for its actively managed bond funds, Vanguard has shown that active does not have to equal expensive. The debate, then, should be reframed; it’s not so much about active versus passive, but about high-cost versus low-cost. Quite simply, the odds of outperforming a majority of similar investors increase if investors choose the lowest cost for their preferred strategy.

1. ETFGI, as of June 2019.
2. Morningstar, Inc, as of December 2018.
3. Vanguard Investment Strategy Group, 2019. Exchange-traded funds: Clarity amid the clutter. Valley Forge, Pa.: The Vanguard Group.
4. Vanguard Investment Strategy Group, 2019. The case for low-cost index-fund investing. Valley Forge, Pa.: The Vanguard Group.

Originally Posted on September 20, 2019 – Bond ETFs: The Case For Indexing

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The information contained in this document does not constitute an offer or solicitation and may not be treated as an offer or solicitation in any jurisdiction. This document is issued by Vanguard Investments Hong Kong Limited (CE No. : AYT820) which is licensed with the Securities and Futures Commission (“SFC”). The contents of this document have not been reviewed by SFC. Investment involves risk.  Past performance is not indicative of future results. Copyright, trademark and other forms of proprietary rights protect the contents of this document. You may not copy, publish and/or distribute any derivative works from the information from this document.

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