Talking Heads – Taking an active look at trends in Fixed Income ETFs

This is an audio transcript of the Talking Heads podcast episode – Taking an active look at trends in ETFs

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking Heads Podcast. Every week, Talking Heads will bring you in-depth insights and analysis through the lens of sustainability on the topics that really matter to investors. In this episode, we’ll be discussing fixed income ETFs. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by Luca Pagni, Portfolio Manager. Welcome, Luca, and thanks for joining me.

Luca Pagni: Thank you, Daniel. It’s really a pleasure to be here.

DM: Luca, we think about the astounding growth in ETFs and in passive investments in general over many years now. But one thing that’s been a change are the different types of ETFs that are available to investors and their popularity. We’ve seen a lot of evolution over the years, particularly around fixed income, which initially was seen as more challenging to present in an ETF form. But the industry evolves and comes up with creative solutions. So, could you talk a bit about what you’ve seen in terms of the success of fixed income ETFs and what you think is behind it?

LP: In recent years, the fixed income ETF have become an essential tool for asset allocation, and this is also due to the steady growth in product offering. There are a few reasons behind the success, really. First, it’s important to observe that most bonds are not traded on the stock exchange like equities are. Bonds are generally traded over the counter, which makes them less accessible to the general public. Fixed income ETFs directly solve this problem by making bond investment available on the same market where shares are listed. So, it’s much easier for the general public to access bond investments. The second fundamental advantage of fixed income ETFs is the diversification they provide to the investor. This level of diversification is really difficult to achieve in the bond market. Just think about the fact that to buy a single bond, most of the time you need at least EUR 100 000 because that’s the minimum denomination. So, if you want a decent diversification in your portfolio as a private investor, that’s going to be challenging. On top of that, some of the segments of the bond market have very low liquidity, and it might be challenging for the individual investor to put money into them. ETFs offer diversification that solves these two issues, and this is no matter the size of the investment that you have to put into that market. Another critical factor is liquidity and there are multiple ways that this can be achieved. One is the use of portfolio trading. Now, portfolio trading is a technique whereby you trade a basket of bonds rather than individual lines of bonds. The trade is more efficient and also less costly. It’s cheaper from a trading cost point of view to trade the ETF rather than the underlying securities. It’s a very important attribute and advantage of these products over investing directly in single bonds. Finally, I would say that it is interesting to notice that a major index provider like, for example, MSCI, is entering the bond market in terms of index production. They really see big growth potential.

DM: Can you go into a bit more detail about some of the evolutions, some of the innovations that you’re seeing within fixed income ETFs?

LP: Fixed income ETFs have grown in diversity in recent years, and they are now really offering a wide range of strategies and market sectors to the investor. An investor can now select ETFs on all the relevant bond market segments such as government, emerging market, corporate. And this is across different rating profiles and maturity profiles. One of the recent developments is thematic bonds. We all know thematic bonds such as green or social bonds, and now [they] can be accessed with dedicated ETFs. Fixed income ETFs is expanding into more illiquid and hard-to-reach segments of the market, such as Chinese or Indian bonds. Another notable development is the introduction of fixed maturity ETFs. Those are products that offer a diversified exposure to a certain bond market, but with a final maturity date. The fixed g maturity fund behaves like a normal bond with decreasing duration over time, and this allows investors to lock in an attractive yield while still diversifying away individual credit risk, which is a key element, as we said before. And it’s interesting to note one third of the new issued fixed income ETFs that were issued in Europe in the last 18 months were fixed maturity ETFs. Let me finish with another significant evolution, which is the growth of actively managed ETFs. You know that ETFs are generally considered to be passive products, so vehicles that are used to replicate a market performance. But the recent launch of actively managed ETFs highlights the fact that ETF can be a vehicle for strategies that have also the aim to outperform the market.

DM: You’ve talked [about] how with these active ETFs the portfolio manager can add value to the product and take it beyond just what we call plain vanilla ETFs, where it is very much 100% passive. Can you maybe talk about some other techniques, shall we say, that portfolio managers use to add value to the ETF product?

LP: Replication should not be considered as a completely passive wave of managing a portfolio. This is a very important point for us as portfolio managers in the space ETF. Portfolio managers can employ various techniques to improve replication beyond the simple mirroring of an index. And the way we approach ETF management today is more proactive than it was in the past. Our aim is always to reduce as much as possible the tracking error towards the index, but we can add goals like reducing the transaction costs, reducing turnover and improving the liquidity of the portfolio. And we have various tools at our disposal to do this. For example, we can participate in the market for new issues in anticipation of their inclusion in the index. Another example of proactive management is how we treat the daily inflow outflows in the fund. We are now much more attentive to market positioning in each individual bond, and we can capitalise on this information when we adjust the portfolio. In essence, when selecting the bonds, we want to trade, we can favour those with strong market buying interests and reduce those that have large selling pressure, for example. You can have the goal of reducing turnover in the portfolio, improving the liquidity of the portfolio. In this way, we can improve resilience and reduce the transaction costs. And finally, one of the sources of portfolio technique improvement is the need to respond to certain clients’ concern. ESG integration into portfolio has been one of the most important themes in the last few years. ESG integration can impact the performance of the portfolio compared to the broader market, and [an] ESG portfolio may lag or even outperform a broad market. So, to address this issue, we launched a sustainable range of fixed income ETFs. These products have superior ESG profiles compared to the market they follow. All these innovations in ETF investment management are challenging and exciting for us. That demonstrate the flexibility and capability of portfolio managers to meet clients’ needs in an effective way and even in a space where you think that the portfolio management is relatively passive.