Australia's exchange-traded funds (ETF) sector is about to go into overdrive as expectations of a substantial volume increase are set to become a reality after the first fixed-income ETFs were listed on the Australian market. Bond ETFs will experience growth of up to $500 million within the first 12 months, one provider anticipates.
As an asset class, fixed income has been underused. Direct ownership has been difficult for retail investors due to access and a large investment minimum, but through ETFs, the issue of access is now removed. Its defensive qualities to equities have investors, mainly self-managed superannuation fund (SMSF) trustees, curious to explore the new reality.
Russell Investments was the first to offer government, semi-government and corporate bond ETFs, followed by BlackRock, which listed its iShares composite and treasury ETFs. Vanguard is the latest to unveil its government bond ETF, while State Street Global Advisors is yet to announce its launch date.
BetaShares also stepped in with the first cash ETF in Australia, offering cash 'at call' through the ETF, a high interest rate, monthly distributions and no exposure to fluctuations in bonds to achieve yield.
Overall growth in the ETF landscape will occur rapidly, helped by new players expected to enter the market this year, according to ETF Consulting principal Tim Bradbury.
The new ETF issuers will either be similar to an asset manager or a financial services player that is a little left-of-field, such as the entity that issued the Digga Mining Fund ETF.
Bradbury warns that such competitors will take a slice of the market share if the larger issuers don't provide ideas to the market that appeal to advisers. "If you think about what the big players have done, they've rolled out a lot of what's worked well around the world and that's fine, but once there's a different demand locally, there's an opportunity for an issuer to get in and get some assets," he says.
He forecasts Australia will have a total of around 100 ETFs by December
Fixed-income ETFs
ETFs will get a massive leg up this year following the 10 January announcement by the Australian Securities Exchange (ASX) that the AQUA operating rules would expand to allow fixed-income products, covering off ETFs.
The latest arrival has sent the industry into a frenzy, with a BlackRock Investment Institute report finding fixed-income exchange-traded products reached $9 billion in January 2012, a new global record.
"The lag between the conventions that we see in North America and how quickly they're taken up here and in Europe is the tricky thing to determine," Standard & Poor's (S&P) director and head of index services Guy Maguire says.
"But we're just going to naturally see more diversification. That's one thing about Australia that won't necessarily hurt how portfolios change."
Russell Investments foresees bond ETF growth of up to $500 million within the first 12 months.
"Fixed income has certainly been the asset class that's been getting a lot of attention as it's going to provide an opportunity for investors to look at building a broader portfolio of ETFs. It's certainly going to be a more cost-effective solution for investors," Russell director of Australasian ETF product development Amanda Skelly says.
"Canada is a very interesting case study in that it's a similar size to Australia and its ETF category is now around $25 billion to $30 billion and we're still at $5 billion. So there is definitely scope for our market to grow substantially. Fixed-income ETFs will certainly help because it'll enable an investor to look at their whole portfolio in an ETF framework and really start to make ETF model portfolios."
There will be a much greater need for investment products based on assets that have more security of capital and a regular income stream, Vanguard Australia head of product development and management Robyn Laidlaw says. "That's exactly the role that bonds do play in a portfolio - they offer diversification from equities and more of that capital security and regular income stream. That, I think, is quite timely [as] the structural change we're seeing is an increased number of retirees and as we see that demographic of the retiring baby boomers in Australia," Laidlaw says.
Skelly says fixed-income ETFs should be seen as a complement to cash and hybrids, rather than a replacement.
"We're recommending that investors don't move from term deposits into bond ETFs; it should be used as a complement as we're aware many investors are concerned over capital stability at this time," she says.
"Bond ETFs do have low volatility compared to equities, whereas term deposits don't have any volatility in their capital but there is a risk that inflation can erode your capital."
Furthermore, the recent rush to hybrids is worrying, she says.
"People don't really understand how they can act in difficult market environments, in fact, some hybrids can just stop paying coupons and there have been examples of that, Tabcorp. If they don't meet certain earnings or leverage ratios, they will be required to stop paying that coupon," she says.
Education efforts get a boost
The disappointing equity market performance has generally boosted investor knowledge of equity risks, which the industry is now seeing translate to the fixed-income side as an alternative option.
Combined with the launch of fixed-income ETFs, education has become the highest priority for all ETF issuers, collectively agreeing that the success of the products relies heavily on an understanding of the products from both advisers and investors.
"Even talking about the basic characteristics of bonds is still something that we need to educate people on. Add on the ETF complexity, I think it does get harder for certain advisers," Skelly says.
Fixed income is considered less risky than equities or listed property, however, they are not completely risk free. "There's a danger there in having these easily accessed ASX-listed investments that people think they don't need to do [the things necessary] in normally assessing an investment and that's not the case," Implemented Portfolios chief investment officer Jon Reilly says.
"You absolutely need to know what you're buying and you need to know how these things trade.
"There's a couple of issues in trading in particular that a lot of people don't get their heads around and they look at liquidity and debt and get worried, but don't understand the role of the market maker and don't fully understand the creation/redemption mechanism, which is a real advantage in terms of tax efficiency in the structure.
"So while it liberates asset classes that haven't been traditionally available to investors, it doesn't alleviate the need to do your homework and understand what you're buying."
ETF model portfolios
As fixed income completes the asset suite, it is now possible to build portfolios completely from ETFs.
Reilly has been able to see the enormous potential of ETFs, having met with ETF managers and advisers in the United States over the past few years.
"I have looked with envy at what they've been able to construct," he says.
"There's definitely momentum behind the ETF industry as we have more tools to implement portfolios and that will continue as we start to see a more broad range of ETFs.
"If we look at overseas experiences, what I'm expecting to happen here is that we'll get increasingly granular with what we can do with ETFs. However, there's potential dangers attached to that as the more narrow an index that the ETF is trying to track, the more additional costs are involved.
"The more options the better. But as we start to get into those exotic, synthetic and leveraged ETFs, you're tending to get into trading ETFs rather than investment ETFs."
