Fixed interest exchange traded funds can be a useful source of income.
A longer-term effect of the global financial crisis has been the relentless downward move in interest rates as central banks attempt to invigorate their economies. As a result Australian investors seeking income have seen the yield on their cash and term deposit investments fall.
This has led to investors taking on more risk to maintain what they see as a reasonable yield. For many, this has meant investing in hybrid securities issued by the major banks, for some it has been high-dividend shares. One rapidly growing alternative that is generally less risky is the exchange-traded fund (ETF) market.
(Editor's note: Learn about the basics of exchange traded products with the free ASX online course on exchange traded funds and exchange traded commodities.)
ETFs are different from regular managed funds and offer features that deserve consideration. This article focuses on fixed-interest ETFs where, according to YieldReport, returns in the 12 months to the end of February have been as high as 16.35 per cent.
An ETF is simply a fund that holds a collection of investments, such as bonds or term deposits, which is managed by a professional management team. The difference between regular managed funds and ETFs that makes them attractive is fees are very low and the units in the ETF can be bought and sold on ASX just like ordinary shares.
For a regular managed fund, processing of applications to invest or redeem units can take weeks and the exit price may not be known until after the end of the month.
Assets focus a big advantage
ETFs can be focused on any asset class or country-specific asset class, making asset allocation decisions easy and quick to implement. They can be very appealing in the fixed-income asset class because investing in government and corporate bonds is quite often beyond the expertise of smaller investors. ASX investors can choose from ETFs that focus specifically on Commonwealth or semi-government bonds, corporate bonds or inflation-linked bonds.
The most popular fixed-income ETF is focused specifically on cash and term deposits. The specific investment focus and the ease of buying and selling makes it possible to build a fairly diversified portfolio with a relatively modest investment budget.
Cash and bond ETFs
The cash and bond ETF sector in Australia currently has 11 ETFs from funds managers such as Vanguard, Russell, iShares, SPDR and BetaShares. In the cash category over the past 12 months, the BetaShares ETF returned 3.33 per cent.
The best-performing bond ETF was the iShares Government Inflation ETF with a 12-month return of 16.35 per cent. The next best performer was the Russell Australian Government Bond ETF, with a 12-month return of 13.56 per cent.
A number of these funds try to match an investment in an underlying bond index and this gives investors a broad-based exposure to the asset class, rather than exposure to a small number of assets or bond issuers.
The risk-and-return factor
Investors in fixed-income ETFs first need to decide where they want exposure. Government bonds offer the lowest risk but generally provide the lowest interest rate returns. Semi-government bonds issued by state governments are also low risk but with higher yields. Corporate bonds provide higher yields still but carry a greater credit risk than a government bond. Inflation-linked bonds are issued by governments and pay a return adjusted for the level of inflation.
An ETF that tracks the composite bond index invests in around 400 securities issued by governments and corporates, something that would be impossible for a small investor to do themselves.
Investors should review the fee structure of the ETF, taking particular note of the management expense ratio: the fee to run the fund. The track record of the ETF manager is also an important consideration and investors in Australia are well served in this regard.
Another consideration involves looking at the bid-ask spread of the fund to evaluate the ease of buying or selling units. A major feature of an ETF is that the manager is committed to providing a market-making facility for investors.
Because ETFs trade like stocks, buying and selling will mean paying a commission each time and this needs to be factored into the investment decision.
Leading fixed-income ETF Returns
|NAME||ASX CODE||1 year (%)||Management expense ratio (%)||FUND SIZE ($M)|
|Russell Aust Select Corp Bond ETF||RCB||5.377||0.28||80.4|
|Russell Aust Govt Bond ETF||RGB||13.56||0.24||89.2|
|Russell Aust Semi-Govt Bond ETF||RSM||8.36||0.26||143|
|Vanguard Aust Fxd Int Index ETF||VAF||10.34||0.2||131.5|
|Vanguard Aust Govt Bond Index ETF||VGB||11.08||0.2||33.9|
|BetaShares Aust High Int Cash||AAA||3.33||0.18||781.1|
|SPDR S&P/ASX Aust Bond||BOND||10.73||0.24||16.2|
|SPDR S&P/ASX Aust Govt Bond||GOVT||11.33||0.22||5.4|
|iShares Composite Bond ETF||IAF||10.12||0.24||206.4|
|iShares Treasury ETF||IGB||10.97||0.26||17.1|
|iShares Govt Inflation ETF||ILB||16.35||0.26||33.4|
Sources: YieldReport; ASX
Growth of the ETF market
Analysis by YieldReport shows that February 2015 was the biggest month so far for the ETF sector in Australia, with net growth of $1 billion to reach $16.9 billion. The sector grew by almost $2 billion in the first two months of 2015. YieldReport analysis suggests total funds under management in Australia in the cash and bond ETF sector reached $1.538 billion in February with more than half that, $781 million, invested in the BetaShares cash/term deposit ETF.
Fixed-income ETFs are tipped for further growth in the years ahead, ETFs that provide exposure to the fixed-income sector are still a relatively small niche but have been growing swiftly. The sector in Australia appears to be only at the start of the growth curve.
"We have seen significant growth across the Russell Bond ETFs, exceeding 250 per cent in the past 12 months," Robert Moore, portfolio manager for fixed-income ETFs at Russell Investments, told YieldReport. "Much of this has been driven by some institutional investments across our ETFs, but also the retail market, and in particular advisers, are focusing on gaining exposure in the shorter end of the curve."
The sector is undoubtedly becoming increasingly appealing to a wide range of investor types.
About the author
Matt Wilson is CEO of YieldReport, the only independent report in Australia analysing interest rate markets. He started his career in the fixed-interest markets before working in derivatives for many years. He was instrumental in the launch of the equity warrant market in Australia, New Zealand and South Africa, before launching the first CFD business in Australia at IG Markets.
YieldReport weekly newsletter carries regular coverage of the ETF sector and can be obtained by registering.
ETFs and ETPs has useful information on the features, benefits and risks of these products.