Henry Timmons, director of ETFs and Michael Contopoulos, director of fixed income at Richard Bernstein Advisors are on a mission to convey the message that bond ETFs are effectively replacing the underlying bond market in setting price discovery for fixed income assets.
Founded in 2009 and using asset allocation models since 2010, RBA has USD15 billion in assets, largely in ETFs and is heavily focused on the fixed income sector. Contopoulos explains that RBA launched a fixed income only portfolio two and a half years ago. “It is one of our fastest growing products at the firm,” he says. “Especially over the last six to 12 months because for 40 years you didn’t need tactical management. Portfolio managers needed to only be a little overweight duration and a little overweight high yield to perform well because interest rates fell 75 per cent of the time and in the rare times when they went up it was in a strong overall environment for high yield.
“Going forward, we could be in the exact opposite scenario as rates secularly go up. In this environment, you have to be tactical. The lack of liquidity in individual bonds means the traditional manager can’t be tactical – there isn’t enough liquidity to meaningfully change the exposure of their portfolios – but by using bond ETFs, managers can now meaningfully change the portfolio depending if they want to own credit risk or interest rate risk, long duration or short duration or even volatility.”
Timmons believes that bond ETFs are not entirely understood by the investment community. “Hopefully advisers and managers will understand that they can be a helpful tool in one’s toolbox and help people to understand what one can do through a fixed income ETF which you might not be able to do in the underlying security.”
Contopoulos says that what drives returns tends to be macro not micro. “Macro variables drive returns as individual stocks within a sector, style, even region tend to be correlated. Fixed income is the same. What matters most is getting your quality and duration right. Having the ability to meaningfully shift those exposures without needing to sell individual illiquid bonds could deliver meaningful alpha to a portfolio.”
It all comes down to liquidity, he says, explaining that it can be difficult to change the complexion of a very large bond portfolio with three to five thousand bonds as there can be little liquidity in the underlying securities.
“It would be very difficult to change that portfolio as you can’t sell that number of bonds in an efficient way. Using ETFs, you can go to zero in a day.”
“Embrace the bond ETF, don’t fear it,” Timmons says. “There is a myth and prejudice against bond ETFs which comes down to how ETFs are structured.”
And Contopoulos adds that people don’t like the transparency of ETFs in down markets. “When the bond markets are closed, bond ETFs still trade. It’s ironic to me that the ones who are trading the illiquid underlyings are saying don’t buy the ETFs because of the illiquid underlyings.”
