Bond ETFs: Hotter Than Ever

Bond ETFs are hot — not as hot as equity ETFs, but hotter than they've ever been.

Seventy billion dollars flowed into U.S. fixed income ETFs in the first half of this year, suggesting inflows will easily outpace last year's $92 billion, according to Todd Rosenbluth, director of ETF Research at CFRA.

Asset managers are responding to the growing demand by introducing new fixed income ETFs — seemingly a new one every day, says Rosenbluth — and filing with the Securities and Exchange Commission to introduce even more.

BlackRock launched four new corporate bond ETFs in mid-July — three investment-grade corporate ETFs, including two with positive ESG ratings, and one high-yield.

At the same time, Nuveen filed a registration statement with the SEC for its first ESG bond ETF, the NuShares ESG U.S. Aggregate Bond ETF, months after it launched a suite of equity ESG ETFs. Columbia Threadneedle filed with the agency a registration statement for the Columbia Diversified Fixed Income Allocation ETF, a multi-factor smart beta ETF.

Smart Beta More Popular Than Ever

Many of the new bond ETFs are smart beta funds, which track indexes that, unlike traditional indexes, are not market weighted.

The introduction of these funds is "an extension of the evolution of smart beta" equity funds that asset managers have launched, according to Phillip Yoo, ETF analyst at Morningstar. "They want to replicate that success now in the bond ETF space."

In fact, growth in smart beta strategies is accelerating at a rapid pace, according to a new report from FTSE Russell.

Allocations to smart beta strategies reached a new peak of 46% of global asset owners, up from 36% last year — an increase of 10 percentage points, or almost 28%, according to the fourth annual FTSE Russell Global Institutional Smart Beta Survey.

Another 25% of asset owners are currently considering using smart beta strategies, indicating a "healthy pipeline" for future allocations, according to the survey.

"The survey results suggest that growth in smart beta is likely to continue at a robust pace," said Rolf Agather, managing director of North America Research at FTSE Russell.

Asset owners with $1 billion to $10 billion in assets under management led the increase in use of smart beta strategies in the past year, and adoption was strongest in Europe, where 60% of asset owners reported a smart beta allocation, followed by Asia Pacific (48%), then North America (37%).

European asset owners and asset owners with over $10 billion in AUM were also the most interested in applying ESG considerations to smart beta strategies.

Sixty percent of European asset owners showed interest in ESG criteria compared with just 20% in North America, and the primary motivations for both were based more on investment goals — including risk reduction, returns and diversification — rather than social goals or regulatory requirements, according to the survey.

Among individual smart beta strategies, multi-factor strategies were the most popular, with 64% of survey respondents reporting using such a strategy, followed by low volatility (47%) and value (34%). Those three strategies are also the most popular among asset owners currently evaluating smart beta strategies.

Maximum diversification, minimum variance and equal-weight strategies were the least popular smart beta strategies, with equal-weight at the bottom of the pack, used by just 6% of smart beta asset owners. But almost three times that percentage of asset owners are currently evaluating equal-weight strategies, according to the survey.

ETF Demand Not Just in Retail

Morningstar's Yoo says demand for bond ETFs is coming not only from retail investors and advisors but also from institutional investors using bond ETFs for more efficient overnight lending and hedging purposes.

Total bond ETF assets, including traditional index ETFs and smart beta funds, have grown at a compounded annual rate of 36% over the past 10 years, from just $20.5 billion in 2006 to almost $450 billion by the end of 2016, according to a study by Cerulli Associates and BlackRock, whose iShares fixed income ETFs account for about 50% of those assets.

In 2016, inflows into bond ETFs represented one-third of the flow into ETFs overall, according to the report.

As part of the study, Cerulli surveyed 378 financial advisors with assets under management of at least $50 million and found they are increasing their use of bond ETFs for reasons of diversification, low fees and transparency, and as a substitute for individual bonds and bond funds. Tax efficiency is less of a consideration for bond ETFs than equity ETFs.

Advisors are using bond ETFs to invest in broad categories of the fixed income market, including investment-grade corporate, high-yield and short-term bonds, but future use will more specifically reflect their sentiment about bond market conditions, according to the report. Those anticipating higher rates and inflation will increase their use of floating rate, short-duration and inflation-protected ETFs, the report found.

But they shouldn't invest in any fairly new bond ETF or one whose asset size is less than $100 million, says Yoo. It's uncertain how bond ETFs will behave when the interest rate regime changes, which has already begun, and backtests for new funds reflect a limited history when rates were extremely low due to central bank policies, which are in the process of ending, says Yoo.

He suggests that advisors hold off until a fund has a track record and, for older funds, they should check the sponsor's track record in terms of fund launches, the bid/ask spread over the past year and the rationale behind any smart beta or niche fund.

The proliferation of bond ETFs is not necessarily due to rising demand alone. In the case of smart beta funds, some companies, such as BlackRock, are "trying to get ahead of the curve and grab market share," Yoo says.

— Read Vanguard Announces Treasury-Only Policy for Several Government Bond Funds, ETFs on ThinkAdvisor.