Future Of The ETF Industry: Part II

by on November 19, 2009 | ETFs Mentioned:

The rise of the ETF industry has been impressive, expanding from virtually no listings ten years ago to about 900 today. And there is still plenty of  room for growth. As we head towards the end of a wildly successful year for the ETF industry, ETF Database is taking a look forward, making our predictions for what the future holds. To us, the industry’s future is a bit of a paradox: we are certain that it will continue to expand at an impressive rate, but uncertain as to which new or existing product areas will drive this growth.

Earlier this week, we took a look at the first area of the ETF market that we expect to expand significantly in coming years, delving into the relative paucity of targeted ETFs focusing on economies outside of the U.S. (which we published before IndexIQ filed details on 13 new ETFs, including nine country-specific small cap funds). Today, we shift asset classes to another look at another corner of the ETF market that we feel is severely underdeveloped: corporate bonds.

Bond Issued By The San Francisco Pacific RailroadAccording to our ETF Screener, there are now more than 630 U.S.-listed equity ETFs, compared to only 80 fixed income bond funds. And the vast majority of these bond ETFs focus either exclusively or primarily on Treasuries of various maturities. If the 630-to-80 imbalance isn’t staggering enough, consider that there are only four ETFs that invest exclusively in corporate bonds, including three “junk bond” funds (HYG, JNK, and PHB) and one true investment grade corporate bond ETF (LQD).

Ben Graham must be rolling in his grave. While the legendary investor’s strategies are often associated with equities, high-quality corporate bond ETFs were central to his investment philosophy (21 of the 52 chapters in Security Analysis deal directly with fixed income investing, and several others touch on it at least tangentially). Graham often advocated allocating portfolios 50/50 between stocks and high quality bonds, with changes in certain market conditions justifying moderate changes in this allocation (see a good summary of Graham’s focus on fixed income investing in this PDF). ETFdb Pro members can see how we apply these theories to our Ben Graham All-ETF Model Portfolio (if you’re not a Pro member yet, you can sign up for a free trial or read more here).

Graham had a significant impact on countless investors (including one nicknamed the “Oracle of Omaha”), and while corporate bond investing isn’t nearly as sexy as stock picking, most rational investors have embraced it as an essential components of a balanced portfolio, particularly those that focus on preservation of capital first, and growth of assets second.

Roadblocks Ahead

There are legitimate reasons for the underdevelopment of the bond ETF space, one of which is related to the depth of the most popular bond indexes. Benchmarks such as the Barclays Capital U.S. Aggregate Bond (which underlies AGG, LAG, and BND) weren’t designed with the intention of actual replication by ETF issuers, but rather to be barometers of broad-based market performance. This index consists of more than 8,700 individual bonds, making exact replication through an ETF prohibitively expensive.

This means that bond ETFs use “sampling” strategies to match coupon rates, durations, and yields of the related benchmark. AGG, for example, holds about 265 bonds, or 3% the number in the actual index. While bond ETFs generally match the performance of the index closely, correlation certainly isn’t perfect. But the fix to this problem is relatively simple, and has already been implemented in some cases. The iBoxx $ Liquid Investment Grade Index, to which LQD is linked, has just 100 components.

There’s another potential problem with bond indexes: many of them determine weightings based on total debt outstanding, meaning that issues from the most burdened companies get the largest allocations. The team at Index Universe took a thorough look at this issue earlier this year, concluding that there is significant room for improvement in both the underlying indexes and the ETFs themselves.

Future Of Corporate Bond ETFs

There are clear signs that an expansion of the general fixed income ETF space is underway. According to data from the National Stock Exchange, fixed income ETFs have seen cash inflows so far in 2009 of nearly $35 billion, more than double the tally at this point in 2008. By comparison, domestic equity ETFs have seen cash outflows of about $30 billion.

There are numerous options for investors looking to gain fixed income exposure through Treasuries and debt issued by government-sponsored entities. But with interest rates near historic lows and expected to remain there for some time, the returns from these securities simply aren’t appealing.

LQD is a great exchange-traded fund, offering desirable liquidity (more than 1 million shares traded daily) and competitive costs (expense ratio of just 15 basis points). We think it should be a component of most investor portfolios, and include in several of our all-ETF model portfolios. But its scope is broad, and there are no ETF alternatives for investors looking to gain targeted exposure to corporate bonds. ETF investors looking to overweight industrials bonds or short term corporates are out of luck.

The middle ground between low risk T-Bill ETFs and riskier equity ETFs is virtually deserted, and we think due for significant expansion in coming years. Just last week, Claymore filed for approval on ten corporate bond ETFs targeting specific maturities. We think this could be just the tip of the iceberg, and wouldn’t be surprised to see a wave of sector-specific and duration-specific ETFs launched in the next 12 to 24 months.

Monday: Future Of The ETF Industry: Part I
Today: Future Of The ETF Industry: Part II
Coming Next Week: Future Of The ETF Industry: Parts III and IV

Disclosure: Long JNK, LQD.