The Coming Bond ETF Boom

by on September 14, 2009 | ETFs Mentioned:

Despite my best efforts, I doubt we’ll ever see a definitive end to the debate over active stock picking versus passive indexing. Both sides have their staunch advocates, and in a strange way, both strategies need each other to survive.

Maybe the fixed income space will be different.

Last month, the Wall Street Journal’s Sam Mamudi covered the release of a study indicating active management of fixed income investments lags passive benchmarks with startling frequency. Among the study’s findings:

  • 98% of mortgage-backed securities lagged their benchmark over a five-year period
  • 92% of long-term investment grade bond funds trailed their benchmark over the same period
  • On an asset-weighted basis, index returns beat actively-manged funds in 11 of 13 fixed income categories over one and three years and in all 13 categories over five years

Despite this compelling data indicating that passive indexing may be a superior strategy for fixed income investments, the bond ETF space remains surprisingly undeveloped. There are about 70 fixed income ETFs in our ETF Screener, compared to more than 600 equity ETFs and 85 commodity funds. And the majority of these bond ETFs are dominated by holdings in debt issued by the U.S. government and U.S. agencies. Options for investors looking to gain exposure to corporate bonds, either investment grade or high yield, are limited to only a handful of pure play options. This is a stark contrast to the equity ETF industry, where nearly every niche of the investable universe comes with multiple options for gaining exposure.

Times Are Changing

There is reason to believe the fixed income ETF space is changing. Perhaps the biggest development is the entrance of Pimco into the ETF industry. The dominant bond mutual fund firm has already launched several funds designed to compete head-to-head with existing iShares products, an indication that we may see some downward pressure on expense ratios is the fixed income space.

But to date Pimco’s product offerings have mirrored those already existing: launches and filings have largely focused on Treasuries, not corporate bonds.

Elsewhere, the industry’s #3 player is planning to ramp up its bond ETF presence as well. Vanguard recently announced that it will launch seven new bond ETFs shortly, including both Treasury and corporate bond funds.

Growth Spurt

We often see speculation on the future of the ETF industry. After years of rapid growth, some industry insiders believe we are nearly due for a consolidation of both ETFs and ETF issuers. I disagree for a couple of reasons. First, there are hundreds of ETFs that have been in existence for less than three years. Given the importance of Morningstar “star ratings” (and other widely-accepted measures of fund quality), many in the advisor community have been hesitant to even consider these investments. As these funds mature (if you can call the three year mark a maturity) and get their rating from Morningstar, I would expect they would see a huge surge in popularity (and more importantly, cash inflows).

The second reason is more related to the subject of this piece: the corporate bond market remains tremendously undeveloped. Investors looking to make a play on the investment grade fixed income sector really have only one pure play: LQD. The high yield sector is a little more developed, consisting of a whopping three ETFs (HYG, JNK, and PHB).

Last week, we wrote about ten ETFs that don’t yet exist, but might find acceptance among investors if introduced. Not surprisingly, more targeted corporate bond funds were at the top of our list. For long-term buy-and-holders, the current product offerings are sufficient to construct a reasonably well-diversified portfolio. But for more active traders seeking to generate excess returns, fixed income investment strategies are limited by the depth of the product market (or lack thereof).

Within a few year, I imagine we’ll see dozens of targeted corporate bond funds. Investors will be able to shift from “BBB” rated bonds to “AA” rated debt as they see widening credit spreads. And they’ll be able to tilt their fixed income holdings from utilities to financials as the prospects for various industries change. Tactical asset allocation isn’t currently much of an option for ETF investors, but expect that to change soon.

The possibilities aren’t quite endless, but close to it.

Disclosure: Long LQD, JNK at time of writing.