Using ETFs to ‘reset’ bond portfolios

When I began my career in bond asset management, electronic-inventory systems were still in their infancy, so one of my tasks as a junior professional was to monitor the fax machine for the daily broker-generated lists of available offerings.

When I began my career in bond asset management, electronic-inventory systems were still in their infancy, so one of my tasks as a junior professional was to monitor the fax machine for the daily broker-generated lists of available offerings.

It made for a lot of faxes, but it was the only way to achieve the requisite market access.

The market has come a long way since then, supported by electronic platforms that facilitate efficient searching and sorting of securities. How financial advisers and in-vestors can tap fixed income has changed, as well.

Following the introduction of fixed-income exchange-traded funds in 2002, advisers and investors can now view and trade packages of fixed-income securities throughout the day on an exchange.

Over the past decade, that market has exploded. Last year alone, more than $46 billion flowed into fixed-income ETFs in the United States, with investors accessing major segments of the U.S. bond market, as well as many foreign developed and emerging markets.

As a fixed-income professional, the boom in fixed-income ETFs is gratifying, but it also has given your clients a new way to “reset” fixed-income portfolios to their target allocations when combined with mutual funds and individual bonds. As you introduce the concept, however, some key qualifiers are in order.

Since passively managed ETFs seek to track benchmark returns, by definition they won’t attempt to outperform during rising markets or take defensive positions during market declines. A client still trying to capture actively managed fixed-income performance likely will require some education on that point, as well as the relative merits of active versus passive approaches.

Because adherence to a benchmark is a primary goal, advisers must try to avoid “tracking error” — the performance difference between an investment product and its benchmark — when choosing ETFs. Know, too, that as the market has expanded, product offerings have proliferated.

Not every product aligns with a client primarily interested in restoring a straightforward, stable fixed-income allocation to the portfolio.

That said, here are five ways to put ETFs to work:

Staying invested. In the investment-grade market, less than 30% of bonds trade 20 or more days on average monthly. In the municipal market, trading is even thinner. Like mutual funds, most ETFs don’t mature, but they can help put cash to work while the adviser looks for bonds. One can buy an appropriate ETF to maintain market exposure and then sell it when the right bond is found. When coupons are paid or bonds mature, cash can be swept into an ETF so that the client remains fully invested.

Getting diversified. Because bonds trade in larger lot sizes than equities, buying a broadly diversified portfolio is difficult. Historically, many investors have built individual bond portfolios and diversified with mutual funds. ETFs now provide another avenue for diversified exposure, one that can be traded intraday.

Preserving flexibility. Individual bonds are a good source of core exposure and income, but liquidity can be challenging, making tactical investing difficult. Mutual funds offer daily liquidity but lack holdings transparency. ETFs provide a vehicle for pinpointing specific fixed-income exposure, allowing an adviser to adjust portfolio exposure to opportunities quickly.

Refocusing on the core. Re-cently, fixed-income markets have offered numerous return “surprises.” For many investors, returns have neither met expectations nor provided the anticipated diversification and anchor. An indexed ETF can provide a strong portfolio foundation, with transparency around particular exposures and risks. The adviser then can add favored mutual funds and individual bonds to boost yield and tailor the portfolio to goals.

Capturing yield. Bond liquidity is not only inconsistent, but transaction costs can be very high. Mutual funds are cheaper to access, but fees can be challenging. With yields near all-time lows, every basis point counts. Indexed ETFs tend to have some of the industry’s lowest management fees and are typically much more cost-effective to trade than individual bonds, reducing the friction often encountered when putting money to work. Keep in mind that buying and selling shares of ETFs may result in brokerage commissions.

Matt Tucker is head of fixed-income investment strategy at iShares, BlackRock Investments LLC.