Thu, 22 Sep 2011
BlackRock's Matt Tucker discusses notions about fixed-income ETF premiums and discounts, tax efficiency, liquidity, and more.
Scott Burns: Fixed-income ETFs: fact and fiction.
I am Scott Burns coming to you live from Morningstar's ETF Invest 2011 Conference. Joining me today is Matt Tucker, Head of Fixed-Income Strategies with BlackRock/iShares. Matt, thanks for joining me.
Matt Tucker: Thanks for having me, Scott.
Burns: So, you're going to be on a panel in a little bit talking about ETF fixed-income myths debunked. I think there are a couple of myths out there; let's chat about them.
One, fixed-income ETFs don't work. What do you say to people like that? We see a lot of premiums and discounts. When you hear that, how do you respond to somebody when they say "well, I don't use fixed-income ETFs. They don't work."
Tucker: Well, I think the challenge a lot of investors have had for years is they can see their equity portfolio. They can see how stocks trade. They can watch the tickers on the tape and see that move throughout the day, but they couldn't really see their fixed-income investments. And most of the estimates you get for value for a fixed-income fund or investment are end-of-day at best, and so what ETFs have done, they have brought in this new tool, this transparency of price, you can actually go and watch a portfolio of individual bonds trading on an exchange throughout the day and actually getting prices on that. I think people look at that and they say, wow this thing is moving all over the place, what's happening?
Well, that's just price information being reflected in the market, just like you usually see on equities. People just aren't associating that with fixed-income. It's a new idea to actually see price transparency in fixed-income real-time.
Burns: Right. So, along those lines, fact or fiction: Fixed-income ETFs are more volatile than [open-end bond index mutual funds]?
Tucker: So, if you're looking at price volatility and you can just prove this out numerically. If you look over the long period of time, the volatility is actually very similar. So, if you invest in a market like high yield, and the high-yield market has say a volatility of 15%, and you look at monthly volatility in a high-yield ETF like say HYG, it will also be about 15%, but if you look at daily volatility, they are actually different. The ETF actually looks like the full monthly volatility, whereas it looks like volatility is really constrained in a lot of these indices in open-end funds--just because the fixed-income securities aren't trading all the time and you don't see the same price transparency.
Burns: Right. So fact or fiction: ETFs are tax efficient and fixed-income ETFs are tax efficient as well?
Tucker: Well, again the answers are always tough. When we think about tax efficiency there are really two components.
So, when people think about tax efficiency, you think about what taxes am I paying, right? There is really kind of two forms. So, one is going to be income tax, a fixed-income ETF buys fixed-income securities; that income that it distributes is taxable just like any fixed-income investment. But fixed-income ETFs like equity ETFs are capital-gains tax efficient and they tend to distribute lower capital gains than comparable open-end mutual funds or other structures. So, the tax efficiency benefits that people associated with ETFs apply, but it's important to remember it's only the caps gain piece that makes it efficient. Income is income, and it's going to be taxable.
Burns: How big is that cap gains efficiency, just broadly when you look at that? What is the spread between what you see on average in the open-end space versus the ETF space?
Tucker: It's challenging because there are so many different funds in different markets and turnover rates, but generally you see cap gains distributions in the open-end space in a couple of percent range, ... whereas a majority of the fixed-income ETFs in the market, fixed-income iShares in the market, haven't distributed capital gains. So, you're probably talking about a couple of percent difference at the end.
Burns: All right. Fact or fiction again, the ETF leads the NAV?
Tucker: That's always a tough call. This is something we discuss with clients a lot, and with investors. If you actually look at the NAV of a fund, it's an end-of-day snapshot. Now, if you look at the price of the fund, it trades intraday. So, you definitely will see market information reflected first in the price of the ETF, because it's actually trading throughout the day and actually able to take in new information and respond to that.
Burns: All right. Fact or fiction: ETFs bring more liquidity to their underlying markets?
Tucker: And I think we’ve gotten pretty comfortable, this is unequivocal at this point. If we think about the real value proposition for a lot of investors, when you go and you buy the fixed-income markets, if you go and you buy a fund, a typical open-end mutual fund, or if you buy an individual bond, you have to go out and actually trade a fixed-income security. A transaction cost gets incurred because you're entering that market, and you have to cross that market. And depending on the market you are accessing, it could be a couple of basis points for Treasuries or it could be a couple of hundred basis points for high yield. What the ETF does is it creates a layer of liquidity above the underlying market, so investors can exchange value in a fixed-income instrument without actually trading fixed-income securities, and so the roundtrip costs on a lot of these markets now become pennies. So something like HYG, which is a high yield fund, it tends to trade on the exchange with a bid-offer of about $0.02 or two basis points, relative to about 100 to 200 basis points for the underlying securities, and I think that’s a real benefit for investors, because it really reduces the friction they’d normally encounter when entering and exiting fixed-income markets.
Burns: All right. So let’s step away from fact or fiction and let’s just talk about clients and what you are hearing from them. We’ve seen a huge explosion in not only assets going into fixed-income ETFs, but also more products coming on the market. I think the fixed-income space in ETFs is kind of in its golden age of product creation right now. When you're hearing from clients right now, what are the things that concern them most? Are there tools available? Are there things in the works? What is it that you're hearing from institutions and advisors?
Tucker: Well, a couple of big trends have been coming out. So one is this liquidity story is, I think, being understood and really accepted by a much wider set of investors. So in the early days you had a lot of retail investors, advisors, private wealth, they were very active in fixed-income ETFs early on. We’ve really seen a lot of institutions get much more involved now. So just about anybody who invests in the fixed-income market is now evaluating or using a fixed-income ETF as part of their business, because they recognize it’s another source of liquidity, another way to access this market. The other trend obviously, which you mentioned, is that there are just so many products out in the market. I think we're over 150 fixed-income ETFs just in the U.S. That is exploded. There were six at the end of 2006, so we are running about five years.
Burns: When was the first fixed-income ETF? It was 2006, right?
Tucker: 2002 was the first fixed-income ETF.
Tucker: July 22, 2002.
Burns: But then we didn’t another one for a long time?
Tucker: We had four in 2002 and actually two in 2003. And then 2007 represented …
Burns: The big year.
Tucker: Yes, the big year, when things really took off. So, I think the challenge investors are facing is, given this multitude of products and these multitude of providers and structures, how do they evaluate them, and it’s very similar to what’s been happening at the equity side. There are so many products. Investors really need better guidance to understand, what are the characteristics of the products and how should I think about using them. And so I spent a lot of time just educating investors on what the funds are, what’s in them, how they operate, and how they can be used.
Burns: So, one last question, just more of a market [question]. Do investors on the whole own too much fixed-income right now? Have we seen the pendulum swing too far?
Tucker: I think it’s a difficult call about whether investors own too much fixed-income. I mean if you look at the market we are in right now, rates are extremely low. We are close to all-time lows in some of the Treasury markets. So you can make the argument that maybe fixed-income as an asset class is overvalued. But the challenge is that, it’s hard to make a strategic judgment: Do people own too much fixed-income versus kind of more of a tactical market condition. I still think most people own predominantly equities in their portfolio, and that’s probably going to be the reality for some time to come. I think fixed-income plays a real role. I think rather than generalize it, I think about it according to the investor.
Investors who need income and who want to reduce risk still want to use a heavy amount of fixed-income because that’s the best asset class for that, whereas obviously younger investors and those farther away from needing to actually monetize their investment are going to have more equity. But I don’t think we’ve crossed some line: We have too much fixed-income. I think it’s more about people really continuing to remember, what are the risk in returning characteristics of the different asset classes and what role does fixed-income play in a portfolio.
Burns: Well, thanks for answering the tough questions and giving us your outlook.
Tucker: Thank you.