Increasing a wary client’s exposure to risk may start with a fixed income allocation, but the asset class is now fraught with complexity. Janine Mace explains.
As high term deposit rates become a distant memory, advisers are increasingly facing the tough task of convincing nervous investors to re-embrace risk to boost their falling income.
Fixed interest assets may be one solution to this difficult problem, according to Eaton Vance institutional portfolio manager, Christopher Remington.
“As planners work with their clients on stepping into risk with a portion of their cash, fixed income always seems like a natural first step,” he explains.
Natural though it may be, the actual route has become a little more complex as managed funds are no longer the only path. The launch of fixed interest exchange-traded funds (ETFs) onto the Australian market earlier this year has created a range of new opportunities.
However, while ETFs are marketed as an easy way for retail investors to boost their allocation to fixed interest assets, experts warn they are unlike traditional fixed interest managed funds.
“It is a bond return-like vehicle, but with equity characteristics,” explains US-based portfolio manager for Principal Global Fixed Income, Darryl Trunnel.
“Through the course of the cycle your return is the index minus the fees, even though those may be small.”
He believes advisers need to recognise fixed interest ETFs are not just a cheaper substitute for managed funds.
“They are different from a bond fund although they are low cost. They give you access to the market, as it is hard to get suitable diversification – that is unless you are a large investor – but you are giving up a lot,” Trunnel notes.
AMP Capital head of credit markets, Jeff Brunton, agrees there are important differences.
“We understand clients have lost faith in many managed fund vehicles, but it is hard to do fixed interest well outside a managed fund. With a fund we can access the very large and deep bond markets globally,” he explains.
Questions remain on ETFs
Although ETFs have many positives for retail investors, most fixed interest experts are cautious about the fledgling Australian market.
PIMCO's Australian head of global wealth management, Peter Dorrian, notes there is only a small number of fixed interest ETFs currently available and he believes it is difficult to know how they will behave throughout a full investment cycle.
“With ETFs it is still early days in Australia and they only have light trading, so it is hard to see what the liquidity is like. Liquidity is very important in this type of environment and it is hard to say what it will be like in a stressed environment,” he cautions.
“Fixed interest should be the stable and robust part of the portfolio and you don’t want it behaving like equities if markets become volatile. If there are market difficulties, the buy/sell spread could widen massively.”
Stuart Piper, MLC Investment Management’s head of debt assets research, is another with concerns about an early crop of ETFs.
He notes most of the products launched so far cover easily accessible markets like Commonwealth Government bonds, rather than the variety of fixed interest sectors available offshore.
“I’m not a great supporter of ETFs. At least not what is on offer in Australia, as they provide liquidity in an already liquid asset. For fixed interest sectors where it is not liquid and properly managed, ETFs can have a role,” he explains.
Piper believes the size and international nature of the market means managed funds remain a better bet.
“The fixed interest market is a more global market than equities and there is a big universe of bonds to understand and select from for the average financial planner,” he says.
“A well-priced, well-managed bond fund is a better way for retail investors to access the bond market. The attraction of ETFs is you can see it, as it is listed.”
Time for active management
An important consideration when it comes to fixed interest ETFs is their indexed approach and this is a key argument offered against their use by fixed interest experts.
As Dorrian notes: “The index is made up of some issues you would not want to be in.”
Traditionally, indexing was seen as the way to go with many fixed interest investments, but research houses are slowly changing their view on this.
As Michael Elsworth, Lonsec's research manager – investments, noted in a recent interview with Money Management, investors can now benefit from active management of this asset class.
“For a number of years it was difficult to add value in Australian fixed income, but now there is more scope to add value, so it appears there is some benefit to active management. Market dislocations in fixed income have led to greater scope to add value,” he explains.
Dorrian agrees the new investment environment presents significant opportunities for quality active management.
“If you are in the bond market, it is the time to be active, not indexed. Passive management is not the way to go in fixed interest at the moment,” he argues.
Piper believes active management is essential in this unsettled environment. “You don’t want to run a passive fixed interest portfolio, which is the way most of the ETFs are run.”
This cautious view also applies to the credit sector.
“It doesn’t make sense to be passive on credit, as the credit metrics of companies change and this needs to be managed by credit specialists,” he argues.
Brunton agrees: “Fixed interest needs to be actively managed and surveillance on the bonds done everyday. It may be OK for ‘hold to maturity’ investors not to do it, but then who is managing their credit risk?”
Elsworth believes there are subtle differences between fixed interest ETFs and managed funds which advisers need to understand.
“The emergence of fixed interest ETFs is a positive development, but it is important for investors to understand what they are getting exposure to.
"Equity indices are well understood by retail investors, but it is less well understood what the fixed interest indices are trying to measure.”
Different products can be designed to track quite different exposures.
“Some are tracking ‘pure’ Australian Government securities, which tend to be longer duration and have greater interest rate risk.
"Others have more corporate bonds, which have less duration and less interest rate risk, but greater exposure to equity market risk. They are designed to do very different things,” Elsworth notes.
“They provide varying levels of exposure to the different risks in fixed interest investments.”
According to Dorrian, these differences means advisers need to carefully research the products and their structure.
“Some [ETFs] take advantage of cross-listing rules with the UK and US, so they might include US and UK investors,” he says.
“There are also questions about what you actually own in an ETF. Is it the underlying assets or what? The key message to advisers is that what should be uppermost in investors’ minds is how dependable the stream is. It needs to be well diversified and liquid in this environment,” Dorrian notes.
“Markets are still very skittish and although we are somewhat removed from what is happening elsewhere in the world, that nervousness needs to be considered."
