Institutions, such as pension funds and insurance companies, throughout the world are using fixed income ETFs to enhance portfolio liquidity amid a decline in overall underlying bond market liquidity. ETFs mean they can gain exposure to an index without the burden and uncertainties of making thousands of individual trades; they are also a convenient vehicle to park cash when a firm is in the process of transferring funds to a new manager. Moreover, optimisation techniques allow the ETF manager to track the benchmark by purchasing representative bonds, thereby minimising dealing costs.
Regional variations
The North American fixed income ETF market dominates in terms of size and continues to experience significant inflows, with a total of $456 billion in assets and the European market is growing at a fast pace with total assets at $146 billion.
Asia is the smallest market, with fixed income ETF assets of $9 billion, but the region’s investors are significant buyers of non-Asia ETFs, holding approximately $79 billion of iShares ETFs as of end February 2017, $15.9 billion of which is in fixed income iShares ETFs . Nevertheless, ETFs composed of Asian bonds, whether US-dollar denominated or local currencies, are likely to grow.
Currently, ETFs are being used for a wide variety of strategic and tactical applications in the region. The two most common uses, according to a Greenwich Associates paper, “ETFs Take Root in Asian Institutional Portfolios” (2016), are strategic in nature: obtaining core investment exposures and international diversification within portfolios. These strategic uses of ETFs by Asian institutions are being adopted at a much faster pace than they were at a similar stage in North America and Europe.
Asian institutions’ need for liquidity and quick access to support their sizable fixed-income portfolios could also speed up the adoption of bond ETFs in the region.
According to the Greenwich Associates paper, ETFs make up only about 1.4% of Asian fixed-income assets, and only about a third of Asian institutions employ bond ETFs. If Asian investors follow the example of US and European institutions, and broaden ETF allocations to include fixed income, it will have a profound impact on the size of ETF holdings in the region.
However, there are hurdles that inhibit a faster development of the sector. Despite fast growth in primary issuance in many Asian markets, secondary market trading and liquidity remain sub-optimal and fragmented. Asia ETFs should grow as the regions’ disparate domestic bond markets become more integrated.
Regulations also need to be further streamlined to facilitate not only innovative products but also access to ETFs. For instance, in most Asian countries, fixed income ETFs owned by insurers are viewed by regulators as equity rather than bond securities – unlike in the US and Europe. Also, the widespread use of retrocessions favours the distribution of mutual funds, rather than ETFs, to retail investors.
The region’s demographic changes and its funding requirements for infrastructure and urban development are likely to lead to more accessible, sophisticated and harmonised bond markets, which in turn should spur the growth of fixed income ETFs.
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