Fixed-income exchange-traded funds

What is it? Two asset management companies, BlackRock Investment Management and Russell Investments, have announced plans to list fixed-income exchange-traded funds (ETFs) on the Australian Securities Exchange.

What is it? Two asset management companies, BlackRock Investment Management and Russell Investments, have announced plans to list fixed-income exchange-traded funds (ETFs) on the Australian Securities Exchange. ETFs have been sold on the ASX since 2001 but most of those on issue are equity ETFs - none on fixed-income investments..

Recently, the ASX changed its listing rules to allow for the trading of fixed-income investment products.

BlackRock is launching three fixed-income ETFs - iShares UBS Composite Bond Index Fund, iShares Treasury Index Fund and iShares Government Inflation Index Fund.

Russell is also launching three fixed-income ETFs - Russell Australian Government Bond ETF, Russell Australian Semi-Government Bond ETF and Russell Australian Select Corporate Bond ETF.

How it works? An ETF is a registered managed investment scheme, like a managed fund. What makes it different is that it is traded on the ASX. Most ETFs are passive funds, which means they track the performance of an index, such as the S&P/ASX 200. Both BlackRock and Russell are launching passive fixed-income funds.

BlackRock's funds will track bond-market indices, compiled by the investment bank UBS, which are the most widely quoted fixed-income indices in the Australian market. Russell's ETFs will track indices called DBIQ compiled by Deutsche Bank.

Index replication is done physically, which means the asset manager holds a basket of fixed-income securities that will provide a return that closely matches the index return.

Interest paid by bond issuers will be passed through to ETF investors. Russell is offering the alternative of a dividend reinvestment plan.

Pros ETFs are cheap. The managing director of iShares Australia, Mark Oliver, says the management fee for its Composite Bond Index Fund is 0.24 per cent of funds invested that is a $24 annual fee on a $10,000 investment. The fee for the other two iShares funds is 0.26 per cent of funds invested.

Russell will charge 0.24 per cent for its Australian Government Bond ETF and 0.28 per cent for the Australian Select Corporate Bond ETF.

The other cost is brokerage. Online brokers will charge the same rate for the purchase or sale of a fixed-income ETF as they do for any other ASX-listed security - $15 to $30 a trade.

Ease of access and liquidity are other benefits of ETFs. Oliver says investors can get into the bond market with the purchase of a single $100 ETF share. They can follow the pricing of their ETFs on the ASX or a broker website through the day and can trade whenever they wish.

Cons Fixed-income ETFs are an unknown quantity in the Australian market and this raises a couple of questions.

The main one is what level of tracking error investors can expect. ETF managers try to replicate the performance of an index by holding a representative basket of securities they do not hold all the securities in the index.

There will always be some variance from the index return, which is known as tracking error.

Some bond-market securities are already tightly held by financial institutions and institutional investors and this may create liquidity issues. Investors contemplating an investment in a fixed-income ETF may want to see what the tracking error figures look like before committing their money.

Another question relates to the transparency of the investments. Investors in an equity ETF can get a lot of information about the S&P/ASX 200 and other equity indices from the Standard & Poor's and ASX websites.

They can find out what stocks are in the indices, how their compositions change, their trading performance and volatility.

The fixed-income index providers being used by iShares and Russell - UBS and DBIQ - have no track record in providing accessible and comprehensible index information to private investors.

Fixed-income exchange-traded funds

JOHN KAVANAGH EXAMINES THE PROS

AND CONS OF THE LATEST ETFs.