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Portfolio perspectives | Podcast - 13:03 MIN

Talking Heads – ETF investing – Adjusting to the new rates regime

Daniel Morris
2 Authors - Portfolio perspectives
09/10/2023 · 6 Min

Two factors are driving growing interest in fixed income exchange-traded funds. First,  bonds are back with yields at attractive levels relative to the era of low interest rates. Investors can lock in higher yields using a low-cost instrument such as an ETF, as Lorraine Sereyjol-Garros, Head of ETF Sales, explains to Chief Market Strategist Daniel Morris.  

The second factor is demand for sustainable investments. Investors can switch from non-sustainable fixed income assets to sustainable ones via sustainable fixed income ETFs.

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Read the transcript

This is an audio transcript of the Talking Heads podcast episode: ETF investing – Adjusting to the new rates regime 

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis through the lens of sustainability on the topics that really matter to investors. In this episode, we’ll be discussing exchange traded funds, or ETFs. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by Lorraine Sereyjol-Garros, Global Head of ETF Development. Welcome, Lorraine, and thanks for joining me. 

Lorraine Sereyjol-Garros: Thank you, Daniel. 

DM: We’ve seen one of the quickest rises in interest rates over the last two months. For many years, equity was the main investment solution for investors to generate returns, but now 10-year [bond] yields are above 4% in the US and 3% in France. Sovereign bonds have regained their place in balanced portfolio allocations. What can you tell us about the implications for fixed-income exchange-traded funds of this rise in interest rates? 

LSG: The ETF industry has seen a phenomenal growth during the last 10 years. Asset under management are now approaching USD 10 trillion globally and the pace of inflows into these financial instruments continues to accelerate. Last year alone, well over USD 1 trillion of new assets were added to ETFs, largely in US domestic products. We are beginning to see an acceleration of flows into Europe and Asia-domiciled ETFs.  

ETFs have often been viewed as retail financial products, with individual investors using them as a low-cost way of building portfolio. However, we are starting to see larger, more sophisticated institutions coming into this market. The European listed ETF market was booming in August, with inflows above those for the whole of 2022. Assets under management now exceed EUR 1.5 trillion.  

Looking at asset classes, the flows are now split 50/50 between equities and fixed income. For the European listed ETF markets alone, we have seen EUR 13 billion flows into European sovereign bond ETFs, EUR 16 billion into corporate bonds and EUR 5.7 billion into aggregate bond ETFs.  

As to the current environment for fixed-income ETFs, there are two factors driving investor interest. One is the increase in yield resulting from central bank rate increases. Investors are looking to lock in those higher yields for a longer period, using a low-cost instrument such as an ETF.  

Listeners should be aware that these central bank measures have boosted market volatility. ETFs are typically very diversified, which spreads out the sensitivity to volatility and makes for a smoother performance.  

The other factor is the demand for sustainable investment. Investors are switching to sustainable fixed income, just as they did for equity. A large part of this switch is allocated to environmental, social and governance (ESG) fixed-income ETFs. In 2022, 70% of all ETF flows went to ESG ETFs. So far this year, 50% of all ETF flows are going to bond ETFs. That is substantial given that fixed-income ETFs account for only 25% of total assets under management. 

DM: While ETFs in general have been around for quite a while, not everyone may be familiar with some of the features. What are the main features of ETFs and how are they attractive to investors? 

LSG: The main three features of ETFs are that they are transparent, liquid and cost-effective building blocks in portfolios.  

First, there is liquidity. For an individual investor, the cost of buying and selling bonds can be high, whereas an ETF can effectively offer a portfolio of bonds that the investor does not need to analyse, select or buy: The ETF manager takes care of that, which is efficient.  

If the index that the ETF replicates is designed to focus on more liquid bonds, the manager can buy and sell those bonds efficiently, quickly and at attractive prices. For investors holding a share in an ETF, it means they own a liquid asset that can be traded more easily than all the constituents of the index that is being replicated. An ETF can be an efficient way to gain access to the bond market without all the complexity.  

Second, there is transparency. It is clear which bonds are included in the index, so ETF investors know which risks they are exposed to. As for the ETF securities themselves, investors can track liquidity performance and the tracking error in real time as this information is available daily.  

Third, instead of having to spend time finding and trading bonds, investors can focus on getting the allocation of their portfolio right. Investing in an ETF can also reduce the uncertainty over performance that can be the case when you invest actively by selecting and trading bonds yourself.  

I should point out that ETF investors can adjust their allocation to ETFs at any point during market hours rather than being forced to buy or sell positions at the end of the trading day. Liquidity, transparency and focus are all important benefits of investing in ETFs. 

DM: Investors can now choose from broad index tracking products, ETFs on government bonds of specific maturities, emerging market debt, floating rate and inflation-linked bonds. It gives them a range of building blocks to create an allocation suited to their specific needs. The bond ETF industry now has more than USD 2 trillion in assets. What’s behind this surge? 

LSG: Investors have become more comfortable with these instruments and the advantages I have already mentioned. You can access a diversified portfolio of securities at a known price with a single trade. These are diversification benefits. For example, the next 12 to 18 months could bring idiosyncratic risk to the fore as economic growth slows. The diversification benefits of ETF can help to mitigate this potential issue, given the breadth of assets they invest in.  

Investors want more flexible instruments and ETFs meet such a requirement. In addition, bond ETFs have proven reliable through different economic scenarios. Many viewed the Covid-induced market turmoil in 2020 as a real test for how bond ETFs would function under pressure, as liquidity evaporated in many parts of the fixed-income markets. But price transparency and price discovery remained intact, and there were no liquidity issues affecting redemptions.  

We saw a similar scenario play out this year during the US banking crisis. Reliability, flexibility and diversification can be seen as the three vital qualities that investors will look for as they seek to navigate the challenges ahead. 

DM: One challenge that is certainly at the top of all our minds is climate change and the transition to a ‘greener’, fairer economy. Where do ETFs fit in? 

LSG: Investors are putting much more thought into how to successfully embed better environmental, social and governance standards into their fixed-income investments. There is an ever-growing array of ESG indices. They provide greater choice for investors to target the type of sustainable outcome that aligns best with their objectives.  

The types of indices available range from those screening out controversial businesses to those overweighting companies with a strong ESG rating or even climate thematic and so-called Paris aligned benchmarks.  

We believe we have a strong, sustainable investing approach. We select index providers by reviewing their index construction methodology, including sustainability criteria, the ESG characteristic of the index, and the strengths of the index providers. We look for index rule books that are aligned as closely as possible to a responsible business conduct policy. And we monitor and engage with the index provider to adjust the rule book when we find large discrepancies.  

We also use our stewardship team to engage with selected constituents of the ETF index to encourage them to improve their sustainability practices, track their progress and report back to stakeholders. We believe that given the size of our holdings in corporate debt, we can influence companies through issuer engagement. I see this as a starting point for engagement with all fixed-income issuers. 

DM: Lorraine, thank you very much for joining me. 

LSG: Thank you, Daniel, for having me. 

Disclaimer

Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
Environmental, social and governance (ESG) investment risk: The lack of common or harmonised definitions and labels integrating ESG and sustainability criteria at EU level may result in different approaches by managers when setting ESG objectives. This also means that it may be difficult to compare strategies integrating ESG and sustainability criteria to the extent that the selection and weightings applied to select investments may be based on metrics that may share the same name but have different underlying meanings. In evaluating a security based on the ESG and sustainability criteria, the Investment Manager may also use data sources provided by external ESG research providers. Given the evolving nature of ESG, these data sources may for the time being be incomplete, inaccurate or unavailable. Applying responsible business conduct standards in the investment process may lead to the exclusion of securities of certain issuers. Consequently, (the Sub-Fund's) performance may at times be better or worse than the performance of relatable funds that do not apply such standards.

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