Don’t look now but there’s a new financial product on the horizon that will further threaten the cosy world of our highly-paid fund managers – and this time it’s fixed income managers under the spotlight.

But this new competitive threat offers benefits for investors, especially those grappling with their own self-managed superannuation fund.

So what’s this hot new product? None other than fixed-income exchange-traded funds or ETFs!

The Australian market now has over fifty different equity-based ETFs to choose from, but even today there’s not one bond market ETF. Up until now, the quirky rules of the Australian Securities Exchange haven’t allowed it.

Times are changing

The good news for investors is that late last year the ASX finally changed its rules to allow bond market ETFs to be listed on the exchange. Pretty soon, investors will be able to choose from a suite of fixed-income ETFs offering relatively stable returns and at very cheap rates.

Unlike those paid to pick stocks, fixed-income managers are paid to choose the best bond market investments – be it government or corporate bonds in either Australia or overseas. To that end, they try to be adept at guessing the direction in interest rates, yield curves and corporate risk premiums. A key part of the game is buying up long-term bonds when interest rates are falling because their capital values will appreciate the most.

Fixed-income funds are an important cornerstone of most balanced investment portfolios and while they generally provide lower returns than equity funds, they come with significantly less volatility.

Another benefit is that bond funds tend to do best when equity funds are at their worst, such as in periods of weak economic growth when interest rates and inflation are falling. As a result, the returns from bonds and equities tend to have low correlation, meaning a combination of the two can reduce portfolio volatility without great sacrifices in expected return.

Last year, for example, the UBS Australian Government bond index – a standard benchmark for local fixed-income managers – returned 12.6%, while the S&P/ASX 200 equity total return index fell by 10.5%. In 2008, this bond fund returned 17.4% while the Australian equity market total returns fell by 38.4%.

Equities vs bonds

And in what may be a surprise to some investors, over the past ten years the average annualised return from this bond index (6.6%) has in fact been a little greater than that of the S&P/ASX 200 (6.2%). Some suggest that means investors should own a lot more bonds and a lot less equities.

I’m not so sure. The past decade has been an exceptional period with two recessions in the United States and the global financial crisis (GFC). When currently low global interest rates start to increase, it will reduce bond returns back to their low single digit rates. And as the global economy eventually recovers from the GFC, it will boost equity returns given price-to-earnings valuations are now at quite cheap levels.

I reckon equity returns will handily beat those from bonds over the next ten years.

Risk reduction

Either way, bonds remain a useful source of portfolio diversification and risk reduction – especially for those either in or approaching retirement.

That’s why the introduction of bond ETFs is such great news.

Like ETFs in general, bond market ETFs usually don’t aim to ‘beat the market’ like active managers, but simply track established bond market indices. In exchange, they charge a relatively low annual management fee. Bond ETFs already flourish in markets such as the United States.

What’s more, the case for bond market ETFs is even stronger than that for equity market ETFs, as surveys suggest active fixed-income managers have even more difficultly consistently beating their benchmarks than equity managers. According to a recent survey by Standard & Poor, for example, fewer than one in 10 Australian fixed-income managers were able to beat their benchmark over a three- and five-year time horizon.

If the development of bond market ETFs in the US is any guide, these products should also prove popular with Australian investors. Indeed, local investors already have around $5 billion invested in equity market ETFs, representing a still tiny, but rapidly growing share of the managed-funds industry.

Some in the industry are working to get the first bond market ETF listed ASAP, and this could be as soon as one to two months if there are no delays. Watch this space!

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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