Fixed income ETFs don’t deliver

Two investment experts explain why passive is not the way to go for fixed income

Exchange-traded funds (ETFs) that invest in fixed income do not offer an inexpensive way to buy the market, according to Kames Capital. That finding contradicts common understanding of ETFs as a low-cost route into major markets. 

While there have been significant inflows into bond ETFs in the last 12 months, there are various issues with using the passive route for bonds.

David Ennett and Jack Holmes, co-managers of the Kames High Yield Global Bond Fund, say: ‘Trackers may claim to let you inexpensively buy “the market”, but in truth they can’t.’ 

Ennett explains that bond indices have thousands of constituents, which makes full replication of the market impractical. ‘Even by attempting to copy the index, passives incur high trading costs which eat away at returns, much more so than the low management fees suggest.’ 

Moreover, he continues: ‘Without experienced managers at the helm, in times of stress an ETF can trade at material deviations from its net asset value, given the [low] liquidity landscape of high yield.’ 

For these reasons, many passives products ‘don’t even try’ to track the market, according to Holmes. For example, he points out that the iShares $ High Yield ETF sets its benchmark as the iBoxx $ Liquid High Yield index, but it only holds half the number of bonds in the index, and it’s currently failing to keep up with its benchmark.

Ben Yearsley, director at Shore Financial Planning, agrees with the Kames managers’ assessment. He says: ‘There are some markets and asset classes not suited to passive investing, and bonds is probably top of that list, followed closely by emerging market equities.’ 

‘I think the points they raise are valid, and although at first glance it looks a good way of gaining exposure to the asset class, I would expect active managers, despite the headline higher fees, to materially outperform over the longer term.’  

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