Special Feature

The evolution of ETFs

In November 2012: more products and lower fees. In Mid-November 2012: ETF product innovation; plus portfolio construction. In December: fixed-income ETFs and lurking liquidity risks. Plus Barry Gordon discusses how to use ETFs in portfolio construction.

Investors intent on income have made fixed-income ETFs top sellers

By Dwarka Lakhan | December 2012

Finding a decent stream of income in the current low interest rate environment is challenging for financial advisors and their clients. Long-term bond yields have hit rock-bottom and short-term yields are effectively at zero. And interest rates are not expected to climb higher for at least another year — leaving yield-hungry clients with relatively few viable options.

With traditional income-producing investments falling short of client expectations, there has been an increasing shift toward income-based exchange-traded funds (ETFs) to meet client needs.

"Fixed-income ETFs — the fastest-growing ETF category, with a 64% growth in assets [under management] so far this year — are resonating with clients," says Rohit Mehta, senior vice president, sales and marketing, with First Asset Capital Corp. in Toronto.

And the lower cost of fixed-income ETFs relative to higher-fee conventional investments, such as traditional mutual funds, results in enhanced returns — making ETFs more attractive to clients seeking income.

"Cost becomes an imperative when making the decision to invest in ETFs," says Michael Cooke, head of distribution in Toronto with PowerShares Canada, a subsidiary of Atlanta-based Invesco Ltd.

The potential cost difference, combined with the fact that few fixed-income mutual fund portfolio managers have actually outperformed their benchmark indices, also factors into clients' decisions.

Fixed-income ETFs provide access to a portfolio of bonds at relatively low prices — typically, says Mehta, at levels available only to institutional investors.

These ETFs minimize risk by providing diversification through a wide range of bond issues, including government, sovereign, corporate, emerging markets and high-yield.

"A combination of actively managed ETFs and rules-based [passive index] strategies," Mehta says, "can meet the income objectives of most clients."

Rules-based strategies also may include an element of active management that aims to outperform rather than replicate a particular index.

Jamie Purvis, executive vice president with Horizons ETFs Management (Canada) Inc. in Toronto and a believer in active management, says: "Most fixed-income indices have inefficiencies due to the nature of the product they track." He adds that some fixed-income issues are small and provide insignificant exposure.

Fixed-income ETFs offer more precise ways to achieve your objectives, says Cooke: "You can surgically, precisely, slice and dice the bond market to achieve specific objectives."

Fixed-income ETFs can divide the bond market into different strategies — such as target term; target maturity; bullets, barbells and ladders; and high-yield — says Vikash Jain, vice president, portfolio management, with archerETF Portfolio Management, a division of Oakville, Ont.-based Bellwether Investment Management Inc. Each of these strategies, or a combination thereof, seeks to benefit from different bond characteristics, such as maturity, duration and the degree of credit risk.

For example, a target-term ETF typically holds investment-grade bonds issued by governments and corporations and maintains a given time to maturity by periodically replacing bonds in the portfolio. A target-maturity ETF holds only bonds with the same maturity date, with the intent of the entire portfolio behaving like a single bond. An ETF using a bullets, barbells and ladders strategy holds bonds of different maturities — short, medium and long. And high-yield bond ETFs hold riskier corporate bonds that offer a higher yield.

Your clients can generate a stream of income using a variety of ETFs. The mix of product comes down to their objectives, says Mehta, and how much risk they are willing to assume to achieve the desired level of income.

For instance, a conservative client whose goal is to preserve capital while generating a stream of income could choose a portfolio comprising ETFs that target investment-grade government and corporate bonds with laddered maturities (60% of the fixed-income ETF portfolio), short-term corporate bonds (10%), short-term government bonds (10%), high-yield bonds (10%) and emerging-market bonds (10%).

Another client, whose goal is primarily income with a high degree of capital preservation, may hold ETFs that target short-term corporate bonds (40%), mid-term corporate bonds (20%), long-term corporate bonds (20%), high-yield bonds (10%) and emerging-market bonds (10%).  IE