New indexing: strategies for bond ETF investors

Investors in listed bonds via ETFs will increasingly have more investment-style choices.

Summary: If you think that all listed bond funds are the same, think again. As well as different investment compositions, there also are different investment styles to consider. While most ETFs are index-based, there is likely to be an increase in ETFs using a “new indexing” approach that, broadly speaking, is closer to active management.
Key take-out: As Australian bond ETF investors seek different vehicles that capture or enhance market returns, there may be an increasing broader range of investment options.
Key beneficiaries: General investors. Category: Fixed interest.

Indexing in Australia has been evolving since the 1990s, from traditional unlisted index funds to listed index funds in the form of exchange-traded funds (ETFs).

Since 2012 bond market investors have had access to listed bond investments in the form of ETFs. The continuing evolution of indexing is likely to lead to “new indexing” – a concept presented as an extension of traditional indexing but which in reality is closer to active management.

Currently there are 10 bond ETFs listed on the ASX (see figure 1) and bond investors will benefit significantly from increased accessibility to listed investments as more products are launched over time. In particular, the difficulties in gaining bond market exposure in the unlisted space is likely to lead to an increase in the number of bond ETFs.

The UBS family of bond benchmarks is generally used as a benchmark for bond ETFs due to the established credentials based on the long history available. Most ETFs are index-based, meaning the ETF is structured to capture the investment profile of the benchmark with respect to risk and return by holding the market capitalisation (market cap) weight of the securities in the benchmark.

More actively managed ETFs are likely as new strategies are developed to entice investors – as well as some current strategies not expressly stated as active. The method of security selection and the number of securities held are not based on market cap weights.

The following issues should be considered when investing in ETFs, such as:

  • The investment strategy: Is it index-based or a “new index” strategy?

An index-based strategy is investing in the market cap weighting of the securities in the benchmark. Generally the underlying fund of the ETF will hold a similar number of securities to capture the risk and return profile of the benchmark. A new index strategy may hold a smaller number of securities in non-market cap weightings – strategies such as holding equal weightings of securities or targeting a factor such as volatility – and the risk/return profile will be quite different to the broad market exposure.

  • The benchmark, and how it is constructed.

The benchmark being used is as important as the investment strategy. A traditional broad-based benchmark that objectively represents an asset class by market cap weightings is in-line with an index-based strategy. New indexing may use a benchmark constructed using different metrics, such as non-market cap weights, volatility or credit quality.

  • The investor’s objectives with respect to return and risk.

An ETF that offers exposure to a broad-based benchmark such as the UBS Composite Bond index comprising government, semi-government, credit and supranational securities may provide an investor with a higher level of return for a required level of risk over the longer term. New index strategies offer different risk/return profiles that can differ significantly to a traditional index fund.

As seen in figure 1, there are four providers of bond ETFs:

  1. BlackRock Investment Management: Of the three bond ETFs, the iShares UBS Composite Bond ETF provides a broad exposure to the bond market, but as it has a significantly lower number of securities relative to the benchmark, due to the sampling process used to choose the securities, there is increased risk that the ETF will not track the benchmark closely with respect to performance. The other ETFs are concentrated exposures to sub-sectors of the UBS Composite Bond Index which, depending on the investor’s investment objectives, may be an appropriate investment option.
  2. Russell Investments: A maximum of 10 securities that are equally weighted. The investment strategy used is less diversified and has more concentrated risk, targeting sub-sectors of the bond market.
  3. State Street Global Advisors: SPDR ETFs use benchmarks with a shorter history than the UBS benchmarks so the risk/return outcome is less predictable. The number of securities selected for the SPDR S&P/ASX Australian Bond Fund ETF is less than in the benchmark due to a sampling process used, which increases the risk of not matching benchmark returns.
  4. Vanguard Investments: Provides a broad-based diversified exposure through its ETFs, holding a majority of the securities in the underlying benchmarks.

Figure 1. ASX listed Bond ETFs

iShares UBS Composite Bond ETFUBS Composite Bond IndexIAF0.24
iShares UBS Government Inflation ETFUBS Government Inflation IndexILB0.26
iShares UBS Treasury ETFUBS Treasury IndexIGB0.26
Russell Australian Government Bond ETF DBIQ 5-10 year Australian Government Bond IndexRGB0.24
Russell Australian Semi-Government Bond ETF DBIQ 0-5 year Australian Semi-Government Bond Index RSM0.26
Russell Australian Select Corporate Bond ETF DBIQ 0-3 year Investment Grade Australian Corporate Bond Index RCB0.28
SPDR S&P/ASX Australian Bond Fund S&P/ASX Australian Fixed Interest IndexBOND0.24
SPDR S&P/ASX Australian Government Bond Fund S&P /ASX Government Bond IndexGOVT0.22
Vanguard Australian Fixed Interest Index ETFUBS Composite Bond IndexVAF0.20
Vanguard Australian Government Bond Index ETFUBS Government Bond IndexVGB0.20

Source: ASX website

Note: MER% is the management expense ratio or the management fee paid to ETF providers.

In the US indexing is often a vehicle of choice for US investors and, according to Morningstar, as at December 31, 2012, 24% of managed fund assets in the US were in index strategies compared to only 8% in Australia. The proliferation of new indexing – more aligned with active management – is behind the success of indexing in the US. New indexing is likely to become more recognised in Australia as fund managers and investors look for different methods of achieving an enhanced return.

“Indexing”, or index-based strategies, may be incorrectly associated with other types of investment strategies used by managers such as: fundamental indexing, enhanced indexing, alternative indexing, or smart beta.

In Australia the market has been slower to take up indexing as an investment option due to the success of active management as well as the growth of SMSFs, and the saturation of ETF listings is also relatively low for similar reasons. But, as Australian investors seek different vehicles that capture or enhance market returns, there may be an increasing broader range of investment options.

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