Trading fixed income ETFs in Europe - Enrico Bruni
The adoption of fixed income ETFs by institutional investors and market makers alike continues to gather pace thanks to the instruments’ flexible and versatile format. Bond investors use them as cost-efficient tools for the implementation of interim beta strategies, while dealers are taking advantage of their index replication efficiency to synthetically hedge a long or short “beta” position.
Enrico Bruni, Tradeweb’s head of the Europe and Asia business, presents the case for fixed income ETFs and discusses the role of electronic over-the-counter platforms in the further development of the industry in his article for Best Execution magazine.
Trading fixed income ETFs in Europe
As the phenomenal growth of bond ETFs in Europe continues, market makers and institutional investors are increasingly taking advantage of the new approach they represent for fixed income trading and portfolio management. Electronic OTC execution venues can further boost adoption of fixed income ETFs, primarily by offering interconnected marketplaces to trade the instruments’ underlying securities.
There’s no doubt that since the European exchange-traded fund market launched in 2000, the pace of its growth has been staggering. Combined assets for ETFs and exchange-traded products listed in Europe have broken through the $500 billion milestone, according to ETFGI, reaching a new record of $511 billion at the end of April.
The rising popularity of ETFs, particularly among institutional investors, is hardly surprising. They are low-cost, tax-efficient investment vehicles offering diversification, scope for innovation, and access to a variety of asset class exposures. Unlike traditional open-end mutual funds, ETFs can be bought or sold at any time during the day, allowing for a multitude of trading strategies.
A recent study by Greenwich Associates found that 25% of European institutions had used ETFs last year. The study also suggested that robust demand for fixed income products, both in terms of number of users and size of allocations, will drive ETF expansion in the years to come.
Despite the dominance of equity-based ETFs, whose market share in Europe currently stands at 68% (ETFGI, 31st May 2015), fixed income instruments have gathered net inflows of approximately $17.2 billion year-to-date, just $282 million below their stock counterparts. In addition, “buys” for bond ETFs on the Tradeweb European-listed ETF platform consistently surpassed “sells” for seven consecutive quarters to the end of March 2015, until a sell-off took hold in the second quarter of the year, reversing the “buying” trend in both equity and fixed income-based funds (see Figure 1).
This shift towards bond ETFs is driven by a number of factors – ease of use, efficient market access and liquidity – increasing their appeal for institutional investors and market makers alike.
Institutional investors have long recognised the considerable advantages fixed income ETFs have to offer when implementing “cash equitisation” or interim beta strategies to make strategic or tactical adjustments to their portfolio allocations.
In the equities world, investors can choose from a wide range of instruments – including ETFs, index futures or index swaps – to invest their cash balances into the market. In fixed income, however, there aren’t as many options for investors wishing to buy in, or remain invested in a specific market; they have to either buy a fixed income ETF or all the underlying bonds. By selecting an ETF, institutional investors are able to instantly gain beta exposure to a particular sector of the bond market in a single trade, and then gradually fine-tune their portfolio allocation.
Using fixed income ETFs as hedging tools
For their part, market makers have been steadily integrating bond ETFs in their hedging toolkits, which were previously limited to derivative-based securities. This is thanks to ETFs’ flexible and versatile format, which enables dealers to take long or short positions quickly and efficiently.
When selecting a hedging vehicle, index replication is vital. Unlike credit default indices, for example, whose constituents are equally-weighted, ETFs typically replicate a fixed income index more closely, allowing market makers to synthetically hedge a long or short “beta” position.
A cost-efficient vehicle for bond investors
Data extracted from the Tradeweb European-listed ETF platform shows that the bid-offer spread on fixed income ETFs can be significantly tighter than that of the underlying basket of securities. For trades executed on the platform between 1st April – 20th May 2015, the average bid-offer spread on the iShares Core £ Corporate Bond UCITS ETF (Ticker: SLXX) was 27.82 euro cents compared to the average spread of 97.5 euro cents for its bond constituents on 20th May. Similar figures calculated for the iShares Euro High Yield Corporate Bond UCITS ETF (Ticker: IHYG), the iShares Euro Corporate Bond Large Cap UCITS ETF (Ticker: IBCX) and the SPDR Barclays 0-3 Year Corporate Bond UCITS ETF (Ticker: SYBD) tell the same story (see Figure 2).
Trading fixed income ETFs
The main challenge for the European ETF market is fragmentation: liquidity for the 2,116 European ETFs/ETPs currently available is dispersed across more than 6,473 listings on 25 exchanges. However, electronic over-the-counter platforms have bridged the fragmentation gap, while simultaneously introducing functionality enhancements, not just around trade execution, but around the availability of data and analytics as well.
Electronic trading venues have also introduced innovation aimed at the fixed income portion of the ETF business. Two years ago, we launched a tool that makes it easier and faster to price and trade the basket of bonds needed for the creation or redemption of shares in European fixed income ETFs. The solution has made it possible for all transactions to take place in a single venue, resulting in a seamlessly interconnected trading experience.
A promising future lies ahead
ETFs are easier to transact than ever. As institutional investors and market makers continue to appreciate the benefits of bond ETFs and incorporate them in their day-to-day workflow, the instruments’ growth, both in assets and trading volume, can only go from strength to strength. Electronic trading platforms can play an integral part in the development of the fixed income ETF space by adding new functionality to increase efficiency and transparency, as well as to improve market infrastructure.
Enrico Bruni is head of the Europe and Asia business at Tradeweb