Many of the innovations in exchange traded funds (ETF) are happening in the fast-growing fixed income area, driven by investors’ thirst for yield, an industry conference was told on Thursday.
“ETFs are nimble, and they’re getting the products out there to meet investor needs,” said Dean Allen head of product management at Vanguard Group Inc. in Toronto at the Exchange Traded Forum, sponsored by Radius Financial Education. “A lot of the innovations are in the fixed income area, including ETFs that search for yield on global basis, covered call ETFs and preferred share ETFs.”
With interest rates at historically low levels, it’s a challenging time for investors seeking income. Other ETF innovations responding to the demand for income include actively managed ETFs that focus on corporate bonds and preferred shares, but allow managers the freedom to deviate from standard market indices, as well as floating rate bond ETFs, laddered bond strategies and “target date” ETFs that have a predetermined maturity date much like an actual bond. On a global basis, ETFs are also emerging as a low cost way to invest in senior loan portfolios that throw off income and have floating rate characteristics.
“Advisors know their clients best and the proliferation of product allows you to slice and dice and pick your space in the industry, whether it’s fixed income or equity,” said Rohit Mehta, senior vice president of sales and marketing at Toronto-based First Asset Capital Corp. “You can get smarter exposure to asset classes and better risk/return characteristics.”
Jaime Purvis, executive vice-president at Toronto-based Horizons Exchange Traded Funds Inc., said actively managed ETFs are particularly useful in the fixed income space where some bonds have poor liquidity and it can be difficult and expensive for ETFs to rigidly track an index in the manner of passively managed ETFs.
“We use active management, such as duration and credit analysis, to pick 80 names out of 325 in the index, resulting in similar yield but less risk,” he said.
Currently, there are about 70 fixed income ETFs listed in Canada, of a total of 276 ETFs, according to industry statistics cited at the conference. In 2012, the strongest cash flows were experienced in the Canadian fixed income category, followed by Canadian equity and U.S. fixed income. In the first quarter of 2013, the biggest net flows were into U.S. equity ETFs, followed by Canadian preferred share and Canadian fixed income ETFs.
The problem with interest rates currently at historically low levels is that any rise in rates will lessen the market value of fixed income securities issued previously at less attractive lower rates. With 10-year U.S. and Canadian government bonds offering an extremely low yield of 1.65%, even a small jump of 50 basis points in interest rates could cause a significant drop in outstanding bond values, said Nicolas Normandeau, vice president and portfolio manager, fixed income, at Montreal-based Fiera Capital Corp. In a rising interest rate environment, solutions could include short duration or floating rate ETFs and preferred share ETFs, he said. Preferred shares are currently offering yields in the 4% to 5% range, offering an income buffer, he said.
“More and more people are going to need income as the population ages,” Normandeau said. “Demand is amazingly strong for preferred shares and the returns are better than corporate bonds.”
Fiera is the manager of the Horizons Active Floating Rate Bond ETF and the Horizons Active Preferred Share ETF sponsored by Toronto-based Horizons Exchange Traded Funds Inc.