The big problem with bond ETFs

When Tesla entered the S&P500 index with a weight of 1.7% at US$695 per share, that single index rebalance was the equivalent in value to 42 years’ worth of fees on a cheap, S&P500 ETF that charges .04%. Thus, if fees were your main driver in selecting the ETF you may be waiting a while to see the value, unless you believe Tesla is worth more than Toyota, VW, Daimler, GM, BMW and Ford, combined.

On Monday April 19, S&P will rebalance their Global Clean Energy index. As the AFR reports, to decrease concentration risk, the index will move from having 30 constituents to 67. Two Blackrock ETFs that track this index have over US$10bn in funds. To rebalance and track the index, all the other holdings will need to be sold down and the new constituents purchased. For two NZ energy companies that appear in the index, Contact and Meridian, Blackrock will decrease Contact’s weight from 4% to 0.7%, equal to 9% of its free float, and Meridian’s from 4.5% to 0.7%, equivalent to almost 8% of its free float.

The sheer weight of money in passive funds is increasing the frequency of these supposedly “outlier” events. For equities, at least there is still the possibility of an upside. An expensive trade into Tesla or the forced selling of a couple of Kiwi energy companies might still leave you with a nice overall portfolio, even if these trades swamp the low fees that made the ETFs so attractive in the first place.

With passive fixed income (bond) ETFs, however, there is an enormous, insurmountable problem: global monetary policy.

Allow me to explain.

A chart produced by Bank of America Merrill Lynch illustrates that current interest rates are the lowest they have been in 5,000 years. It is hard to estimate beyond that because we did not have things like money… or writing. So, it is fair to say that, monetarily speaking, we live in unprecedented times.

This has been scrupulously tracked by all the major global fixed income indexes. They have measured returns in the bond market as interest rates have fallen around the world, to the point where, as Warren Buffett points out, income available to investors in 10 Year US Treasury bonds has fallen 94% since the bond bull market kicked off in 1981. Currently, for the pleasure of handing over your hard-earned cash to the US government for ten years, they will hand you back 1.45% p.a.

Thus, if you own a fixed income ETF that tracks a bond market index, unless interest rates go negative, there is simply no upside in the capital value of your portfolio – and your rate of return is miserably low.

Given the turbocharging of global money printing and stimulus spending that was sparked by the pandemic, there is a long dormant phenomenon that is starting to concern investors: INFLATION.

As interest rates began to tick up in February, those bond indexes faithfully tracked the market and measured the decline in bond values. The index tracking ETFs obediently saw the value of their holdings decline in line with the index. If we do see inflation come back and interest rates rise as a result, your passive fixed income ETF will faithfully measure the decline in the value of bonds, in line with the index.

Bonds are an important asset class and have a place in every portfolio. However, a cheap index tracking broad market Australian bond ETF would have fallen by around -3.2% in the first quarter of this year. If that “cheap” ETF charged, say, 0.2% in fees, then your portfolio outcome was worth around 16 years of those fees. Ouch.

Mark Monfort at ETF tracker recently pointed out that active ETFs can more readily adjust to changing market phenomena and rising interest rates compared with passive funds. Indeed, while the index trackers sank in Q1, active funds generally outperformed with positive returns. In this historically unprecedented situation, investors should look to actively managed fixed income ETFs. Active management in fixed income can ignore an index that measures the tanking of the bond market if inflation were to return. Fortunately for investors, there are many active fixed income ETFs to choose from and more active managers are bringing active bond ETFs to market.

If inflation returns, don’t watch your passive ETF faithfully record a bond market melt-down. Go active and stay positive.

Disclaimer: Please note that these are the views of the writer, Tamas Calderwood, Distribution Specialist at eInvest and is not financial advice.

Tamas Calderwood
Distribution Specialist

Distribution specialist at eInvest, experience in financial services in Sydney, London and New York: FX, fintech, equity research, indexing and ETFs.

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