FYI: Copy & Paste 7/4/14: Brendan Conway: Barron's:
ETF providers are looking for the next big thing -- and they're zeroing in on fixed income. Expect lots of new products, most of which you should ignore.
The never-ending search for the next big thing. Yet those efforts bear an imperfect relationship with what consumers truly want: For every iPad, there's a New Coke. Now, for every Standard & Poor's 500 exchange-traded fund, there's a "New! And Improved!" ETF being launched.
Fund companies are ardently searching for their next big success, and they're increasingly focused on fixed income for their big break. There are 270 bond ETFs on the market today, nearly 40 of which were launched in the past year, and another 160 in the pipeline. But for most investors, it's just a whole lot of New Coke. Or Coke with lime. Or some other unappealing configuration.
Investors know that simpler is better. Nearly half of the $370 billion in bond ETFs is in just 10 broad and straightforward funds like Vanguard Total Bond Market (ticker: BND) and iShares Core U.S. Aggregate Bond (AGG).
Providers are coming up with ever-more-clever ways of constructing bond ETFs. But for most investors, simpler is better.
The new ETFs come in several flavors: Some are narrow slices of the fixed-income market, like subordinated debt and senior loans; some are actively managed; and some are intended for very specific strategies, such as owning corporate bonds minus the interest-rate risk.
Many pros aren't impressed with the new offerings. Bob Smith, president and chief investment officer of Austin, Texas-based Sage Advisory, is particularly skeptical about so-called fundamental indexing, which favors attributes like cash flow or book value over the size of bond issuances: "If it was easy to do, they would have already done it."
The same can be said for active management, and yet investors will see more managers launching actively managed ETFs that essentially compete with their mutual fund. Next up: Jeffrey Gundlach's DoubleLine Capital, which is planning its first ETF with State Street's SPDRs. The DoubleLine ETF will have a broad reach across fixed-income markets, including mortgage- and asset-backed securities. The ETF isn't going to mimic the strategy of the popular DoubleLine Total Return Bond (DBLTX), so it will be free to generate returns from other bond-market corners. "I suspect the DoubleLine bond ETF will likely outperform the Barclays Aggregate and Pimco's total-return funds," says Claude Erb, a former portfolio manager for Trust Company of the West who now researches ETFs. But, Erb says, it is also likely to lose mojo the older it gets.
Erb's research shows that once an ETF reaches just 2% of the asset size of a manager's existing mutual fund, performance slows. Trading costs are one reason, but Erb sees something more important: Managers tend to use ETFs in a way that lends them to a burst of early outperformance. They're very much "best ideas" funds, since the manager can start from scratch with no legacy positions to contend with. So they work wonderfully for a period—and then they don't. That, Erb theorizes, is because great ideas are hard to come by, and the honeymoon eventually ends. That doesn't bode well for the best-known active ETF, the $3.4 billion Pimco Total Return ETF (BOND), which has soundly beaten its older sibling, the $225 billion Pimco Total Return (PTTAX), since the ETF's February 2012 inception. Sure enough, the ETF has slowed its advance; its assets are about 1.5% of its giant older brother's.
SO MAYBE PASSIVE IS BETTER. But just because an ETF is based on an index, doesn't mean it represents the market. Many new ETFs are aimed at solving a problem, rather than delivering the returns of a sector. These "precision" ETFs are tailored for specific uses in your portfolio—many are aimed at somehow hedging interest-rate risk or preserving your initial investment. Two good options are the defined-maturity bond ETFs offered by Guggenheim Investments and BlackRock's iShares. These ETFs own bonds that mature at a specified date, making them good tools for people who need steady income or are interested in laddering. Another example are short- and ultrashort-term bond ETFs, which last year helped investors weather fears of rising interest rates. The $300 million iShares Short Maturity Bond (NEAR) launched in September with an average duration of less than a year. Its 1% yield is relatively rich for short-term bonds.
This precision ETF-making, though, has its dangers, and some companies are willing to go further than others in terms of how fine they'll slice the market. One example is the push by leveraged ETF maker ProShares to launch as many as eight credit-default swap ETFs. What has been turning heads lately are bank loans. In May, Larry Fink, chief executive of BlackRock, grouped bank-loan ETFs with leveraged ETFs as products his firm won't create—they're too risky, and he fears how they'll behave in a steep selloff. "There is an underlying liquidity mismatch," says Matthew Tucker, head of iShares fixed-income strategy at BlackRock, who chose his words carefully as he told Barron's, "We think it could result in an outcome that's different from what investors expect."
Here's what Tucker wouldn't say: If the bank-loan market sells off, a fund like the $7.2 billion PowerShares Senior Loan Portfolio (BKLN) could plunge sharply, as weeks-long settlement procedures inject added risk. Though a spokeswoman for PowerShares says the ETF is an "appropriate vehicle for investors and advisors who understand the senior loan market," it seems clear that in a steep selloff, investors could be surprised at how hard and fast the ETF falls. A Vanguard executive, speaking at an industry conference last year, singled out bank-loan ETFs, saying that Vanguard wouldn't build a "faddish" ETF that risks trouble for investors. A fund of bank loans is a thinner slice of the market than most investors need.
Instead, most investors would do well to follow the lead of Smith from Sage Advisory, who says, "Just because they launched it, doesn't mean I'm buying."
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