For those investors that are searching for liquidity and low management expense ratios, they may get a lot less than they expect in fixed income exchange traded funds. Although, of course, these investments have big advantages, there are still so many downsides that you don’t want to overlook if you’re serious about investing in them.
Fixed Income ETFs
Because of necessity, passive indexing for fixed income is much less passive than indexing for equities. For instance, a share of IBM is likely to be the same in 20 years. For comparison, bonds can be considered as shape-shifters, meaning, for instance, in five or more years, a five-year bond can become a money market bond.
Many bonds are subject to call provisions, which mean that if it’s to the issuer’s advantage, and therefore your disadvantage, they will be refinanced. In the covenant-life issuing periods of 2017 and 2013, the security envisioned by investors may be hugely compromised if the new debt is issued subsequently in a higher security position. Essentially, there will be an active investment management function that cannot be avoided.
ETFs Users and Their Purpose
A huge number of investors use ETFs as instruments to enable easier and more flexible asset allocation. For an investor who wants to switch 20 percent of his portfolio from stocks to bonds, a few clicks on the mouse of a computer can do this.
On the other hand, this forces the managers of the ETF pool into highly liquid assets since he can never know when a withdrawal will take place. As an example, government bonds are the most liquid fixed income investments and the lowest return.
Disadvantages of ETFs
The most comprehensive examination of financial market shows that prices move up and down widely based on alternate waves of optimisms and pessimisms. The price of bonds changes less than those of stocks, but it’s still significant.
The unfortunate downside is that funds will flow into ETFs after markets have climbed up strongly and withdraw near cyclical lows. This turns out especially badly when it comes to fixed income investments. This is because the lesser quality credits can most easily issue debt when optimism reigns.
And that is exactly the time when ETFs will receive the largest inflows. When funds are withdrawn during the inevitable downturn, the manager will be compelled to sell then prices on those lesser quality are falling more rapidly, or because there may be no willing buyers.
Depending on the narrowness of the mandate of the ETFs, the likelihood for sharp fund flows changes, the narrower the definition, the higher the likelihood of a sharp flow fund. A fund that focuses solely on junk may experience massive inflows from investors who are seeking for yield. And they may be withdrawn down to zero when the worm turns. This can spell disaster for a very volatile investment.
The real outcome of these considerations is unpredictable because it is a combination of a function of the market environment, the fund mandate, the skill of the manager, and the buying and selling discipline of the purchaser.
