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Will passive ETFs still outperform in an economic ‘catastrophe’?

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Op-Ed Pumping retail investors with fixed-income ETFs is a fantastic way to make money. Provided you’re the one making the product. With a hard landing on the cards, active bond managers are getting ready for their time to shine.

Fixed income has been an overlooked and misunderstood asset class for most Australian retail investors. Hopefully bonds have our attention now.

The yields on one, two, and three-month US Treasuries are well above 5 per cent. Even one-year yields are getting up there. It was only a matter of time before someone launched a passive fund giving us exposure to short duration US government debt.

VanEck’s 33rd ETF product does just that. The group will list its 1–3 month US Treasury Bond ETF (ASX: TBIL) tomorrow (18 May).

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Arian Neiron, chief executive officer and managing director VanEck Asia-Pacific, said the new product is the first short-term US Treasury bond ETF of its kind listed on the ASX. But there is no shortage of passive bond funds out there. They have been the investment vehicle of choice for unsophisticated investors with 60/40 portfolios. Robo advisers love them.

Launching a passive fund of AAA-rated US government debt appears to make sense. High inflation and rising interest rates have lifted bond yields significantly in the past year. And for those looking for a decent coupon and capital preservation, US Treasuries fit the bill (pun intended).

On an inverted yield curve, short-term bonds don’t just offer a higher yield and coupon — they are also less sensitive to interest rate changes than longer duration bonds, because they simply have less time to be impacted by things.

But a bet is a bet. And an interesting one to make when the US government runs out of cash.

On Tuesday (16 May), US Secretary of the Treasury Janet Yellen told the Independent Community Bankers of America (ICBA) 2023 Capital Summit that Treasury will likely no longer be able to satisfy all of the government’s obligations if Congress has not acted to address the debt limit by early June — and potentially as early as 1 June.

“It is impossible to predict with certainty the exact date when Treasury will be unable to pay all of the government’s bills. And I will provide an additional update to Congress next week as more information becomes available,” Ms Yellen warned.

“Nonetheless, our current best estimate underscores the urgency of this moment: it is essential that Congress act as soon as possible. In my assessment — and that of economists across the board — a US default would generate an economic and financial catastrophe.”

Whatever happens, financial markets are in for a rough ride. Which means smart investors will be seeking out active strategies and putting their money with the pros. Not necessarily to find alpha, but purely to preserve what they’ve got.

The trouble with passive bond investments like fixed-income ETFs is that they ignore the information required to make critical calls and clear predictions in a dynamic macroeconomic environment. And there are far more people invested in passive fixed-income ETFs than active ones.

Index giants like Vanguard have made incredible sums of money selling passive investment vehicles to the masses. For many years, buying an index in global equities or big tech or commodities worked well for the average retail investor.

ETF giants have built their businesses off the bet that unsophisticated investors will remain so.

But bonds are a unique beast and behave differently to interest rate movements. Years of low rates pounded yields into the ground and drove up the face value of the underlying bonds that fixed-income ETFs buy. And rising face values, not unlike the rising market cap of a giant stock like Apple, create distortions.

The growth of passive fixed-income ETFs has created a number of issues.

Bond fund managers make their alpha by executing trades and adjust holdings based on the information they receive. Buying the index in today’s world is a major risk. Particularly if the largest economy on earth is still trying to decide how to avoid a financial catastrophe.

When a decision is finally made, you don’t want to be on the wrong side of the trade.

How financial advisers deal with these times will also come down to a decision.

Either you seek out intelligence in asset management or you seek out passive funds with the largest flows and sexy marketing campaigns. Because underneath the gloss is a financial instrument that is highly sensitive to interest rate changes and very misunderstood by retail investors.

Will passive ETFs still outperform in an economic ‘catastrophe’?

Op-Ed Pumping retail investors with fixed-income ETFs is a fantastic way to make money. Provided you’re the one making the product. With a hard landing on the cards, active bond managers are getting ready for their time to shine.

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Maja Garaca Djurdjevic

Maja Garaca Djurdjevic

Maja's career in journalism spans well over a decade across finance, business and politics. Now an experienced editor and reporter across all elements of the financial services sector, prior to joining Momentum Media, Maja reported for several established news outlets in Southeast Europe, scrutinising key processes in post-conflict societies.

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