For the past several years, many of the biggest pension and endowment funds in the United States have listed exchange-traded funds among their largest internally managed equity holdings, buying ETFs for exposure to international stocks, commodities and precious metals.
These same managers have largely left fixed-income ETFs on the sidelines. The maturation of this market — 10 years younger and still less liquid than the equity ETFs — now has some investors reconsidering.
The $49.6 billion Virginia Retirement System, Richmond, for example, revealed at the end of June that it held 1.7 million shares of the iShares iBoxx $ Investment Grade Corporate Bond ETF, eclipsed by only Apple Inc. for total value in the listed portfolio. Similarly, Stanford University in Stanford, Calif., has reported direct holdings in a pair of iShares bond funds in its $17 billion endowment for the last two quarters. Neither institution would comment on their holdings.
|Moving into the big time|
|The most liquid fixed income ETFs, ranked by average daily share volume as of Oct. 5, 2012.|
|iShares Barclays 20+ Year Treasury Bond Fund||TLT||$2.9||7.7||$950|
|SPDR Barclays High Yield Bond ETF||JNK||$12.3||5.1||$200|
|iShares iBoxx $ High Yield Corporate Bond||HYG||$17.2||3.3||$299|
|iShares iBoxx $ Investment Grade Corporate Bond||LQD||$24.4||1.9||$228|
|iShares Barclays 1-3 Year Treasury Bond Fund||SHY||$8.5||1.5||$122|
Growth in asset size and liquidity of fixed-income ETFs is driving the fresh interest. According to XTF Inc. in New York, long-only fixed-income ETFs totaled $230 billion in assets as of Oct. 16, compared to $852 billion for long-only stock ETFs. Yet the rate at which bond ETFs are bringing in new money, as measured by year-to-date net asset flows, is almost double that of stocks.
Christine Farquhar, a research consultant for Cambridge Associates in London, says that pension and endowment funds assess ETFs differently. “Pension funds need bond products with maximum transparency and minimum tracking error relative to their liability profiles,” says Ms. Farquhar. Endowments, on the other hand, have had “more appetite, especially in less liquid markets.”
Pacific Investment Management Co. LLC, Newport Beach, Calif., estimates that at least 10% of its current $8.2 billion in ETF assets under management is held by pension funds, endowments and sovereign wealth funds, according to Natalie Zahradnik, PIMCO senior vice president and ETF strategist. Noting a significant pickup in questions from clients and consultants this year, Ms. Zahradnik believes the growth of the actively managed PIMCO Total Return ETF (BOND) fund and PIMCO Enhanced Short Maturity Strategy Fund (MINT) — at $3.2 billion and $2.1 billion respectively — “has contributed to new or renewed interest.”
Executives of pension funds and other institutions have used ETFs primarily for transitions and rebalancing, according to a May 2012 from Greenwich Associates, Stamford, Conn. But according to the survey, the fastest growing use of ETFs among institutions has been for an ETF overlay, whereby a manager uses one or more ETFs to replicate the exposure of securities in the portfolio.
For a pension fund looking to hold less cash but also have liquid investments available for sale when making payouts, a large, liquid ETF can be simpler to sell down. Similarly, moving into an ETF might not be as difficult as it would seem with internally managed bond portfolios.
Shifting bonds to ETFs
On Sept. 10, Laurence D. Fink, BlackRock (BLK) Inc. (BLK) chairman and chief executive officer, told an audience at the Barclays Capital Financial Services Conference in New York how BlackRock worked with an unidentified large pension fund to shift 4,000 individual bond issues into four iShares ETFs plus cash. “I believe this is going to transform the fixed-income market,” said Mr. Fink.
Mark Wiedman, BlackRock managing director and global head of iShares, revealed at Morningstar's ETF Invest conference on Oct. 4 in Chicago that the trade in question constituted $1.4 billion of fixed-income securities.
According to market analysis from iShares in July, fixed-income ETFs have only captured 0.3% of the global underlying market value in fixed income, compared to 2.2% in equity ETFs. Moving that even fractionally higher means larger swaths of fixed-income securities consolidated inside ETFs and fewer held directly on the books of institutional investors.
That syncs with the trend in the primary dealer market, particularly for corporate bonds. A September study by TABB Group noted “a dramatic secular change” in which “dealers have pulled back from providing liquidity in the cash market.” Federal Reserve Bank of New York data show that primary dealer inventory in corporate bonds is less than $50 billion, levels not seen since 2003, and far below the 2008 peak of $250 billion.
More assets in bond ETFs has also led to what some believe are pricing distortions, not uncommon for equities in index funds, but relatively new for bonds. For example, the $12 billion SPDR Barclays High Yield Bond ETF (JNK) and the $17 billion iShares iBoxx $ High Yield Corporate Bond ETF (HYG) have been linked to higher prices and greater volatility in certain bonds, says the TABB study as well as a recent report from Goldman Sachs entitled “Assessing the Impact of ETF Flows on Credit.”
Vince T. Lowry, chairman of VTL Associates LLC in Philadelphia, advises caution when it comes to bond ETFs outside of U.S. Treasury funds.
“When rates rise, where are the fund redemptions going to go?” says Mr. Lowry, whose firm is a consultant to defined benefit plans and is also the adviser to RevenueShares ETFs. He hearkens back to phases of bond market illiquidity “when the bids drop,” particularly for mortgage-backed securities in 1987, 1994 and 1999 — not to mention 2008 — and believes dealers will be less willing or able to process significant in-kind redemptions in corporate or high-yield bond ETFs.
Cambridge Associates' Ms. Farquhar notes that one impediment for pension fund investors is the “perception that a high concentration of retail investors (in ETFs) increases the risk of a run on the product, compounding pricing pressure in a stressed market.”
Yet the ability to participate with retail through trading is also an advantage over bonds in a normal market.
Daniel Gamba, managing director and head of Americas institutional iShares for BlackRock in New York, said that before the unidentified pension fund moved into bond ETFs, it “had to see that liquidity of the ETFs was persistent.”
Sourcing that liquidity — to enable institutional investors to get in or out of an ETF position — is still not as simple as checking the book and placing a trade, as it would be in an individual bond or listed stock. Large transactions are best handled through an ETF market-making desk which will walk investors through the impact and total cost of a trade. n
This article originally appeared in the October 29, 2012 print issue as, "More pension funds see value investing in fixed-income ETFs".