Disadvantages of Fixed Income Exchange Traded Funds

Fixed Income Exchange Traded Funds

By necessity, passive management of fixed income securities is much less passive than that of equities. A share of IBM should be the same in twenty years. In comparison, bonds are “shapersMany bonds are subject to call clauses, which means that if they are to the benefit of the issuer (or to the detriment of the investor), they will be refinanced. In 2007 and 2013, “covenant-lightened” issuance periods, a security that investors were considering buying could be heavily hit if new debt securities were issued later and these came with a guarantee. of better rank. Basically,

Rigorous passive management simply transfers the responsibility for managing the investments to the creator of the index. Most indices are market value weighted, which means the entity that issues the most debt securities will have the highest weight in the index. By definition, a global fixed income ETF will have the most securities from the most indebted countries, which contradicts the general rule that good investments are those based on the concept of scarcity.

Who uses ETFs and why?

Many investors use ETFs as an instrument for easier and more flexible asset allocation. An investor who decides to convert 20% of his stock portfolio into bonds can achieve this with a few mouse clicks which will lead him into the “world of ETFs”. Unfortunately for ETF investors, this forces the fund manager to maintain highly liquid assets, as it is impossible for them to know when a withdrawal will be made. As an example, government bonds are the most liquid fixed income investments which, of course, have the LOWEST yield.

The disadvantages of ETFs

Even the briefest examination of financial markets reveals that prices fluctuate wildly with successive waves of optimism and pessimism. Bond prices change less than stock prices, but still significantly. The unfortunate corollary is that funds will flow into ETFs after the markets have risen sharply and pulled back near cyclical lows. This is particularly harmful for fixed income investing, as lower quality credits can more easily issue debt when optimism prevails – exactly when ETFs will receive the largest inflows. Depending on the scope of the ETF’s mandate, the likelihood of large swings in cash flows varies; the narrower the definition, the greater the flow of funds is likely to be. A fund focused solely on “junk bonds” can suffer massive inflows from investors desperate for yield, and can be wiped out when the tide turns: a formula leading to both highly volatile and disastrous investing!

The actual effect of these considerations is unpredictable, as it depends on a combination of factors: the market environment, the mandate of the fund, the skill of the manager, and the discipline of the buyer in buying and selling. . Essentially, every investor should know that investing in fixed-income ETFs is different from the broad-based stock index tracking structures that sparked the ETF boom in the early 1990s.

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