A passive fund manager wants to match the underlying index, not outperform it. But in the fixed income ETF world, it is not as easy as it sounds, according to Raes.
He believes managing a fixed income ETF is more complex than an equity ETF, requiring an additional level of skill beyond managing inflows, corporate actions and distributions.
The equity ETF manager will simply select the names making up its underlying index. But a bond ETF manager has to distill the index by selecting a smaller number of relevant components because the bond universe is larger and each company has dozens of different bonds available. Governments have even more. For example, there are around 300 outstanding US treasury bonds.
“Bond ETFs are typically managed by optimisation, which means that we pick a subset of bonds out of the index,” Raes said.
Factors such as duration, yield, industry and issuer weights are taken into account to select bonds.
Another difference is that most bonds trade over-the-counter and some are held for the long-term in institutional portfolios, making them more difficult to buy than equities. The lack of liquidity results in high trading costs, Raes said.
In order to avoid the high trading costs, ETF bond managers must introduce liquidity into the careful selection of bonds that will properly represent the index. As an example, the BMO Asia USD Investment Grade Bond ETF — the firm’s only fixed income ETF available for sale in Hong Kong — holds about 170 positions drawn from 500 that comprise the Bloomberg Barclays Asia USD Investment Grade Bond Index, according to its factsheet.
“You can match the characteristics of the index reasonably well with a key subset of those bonds, but that skill-set is different from that of equity ETF manager.”
Successful selection by the manager is measured by the ETF’s tracking error, which should be minimal.
In terms of two-year tracking error, the best product among fixed interest ETFs available for sale in Hong Kong and Singapore was the iShares US Aggregate Bond Ucits ETF, with a tracking error of 1.33. The BMO Asia USD Investment Grade Bond ETF was second lowest with 1.46, according to FE data.
The biggest source of tracking error is the selection of individual bonds, according to Raes. “You might have five to ten bonds from a large issuer in an index,” he said. The ETF manager would typically pick only some of them, taking liquidity into consideration.
“When you’re selecting a bond, part of the consideration is looking at trading costs,” he said.
