It pays to be passive when it comes to fixed income. How else to explain the recent surge in bond exchange-traded funds (ETFs), which lead record gains in Canadian ETF assets in March (ETF assets in Canada now stand at $66 billion and three bond funds were the top five gainers)? According to the Canadian ETF Association, the reason investors are flooding into bond ETFs at a time when investors are more jittery than ever about fixed income is cost—better to be in low-fee, index-hugging products than pay for active management in a low-rate environment.
Just as fixed income ETFs are enjoying their time in the sun, providers are looking to create even more bond products to attract investors’ attention. The latest push in the space involves so-called “zero” or “negative” duration ETFs, which are designed to protect investors from rising rates. ETFs that hedge interest rate exposure use a long-short approach, typically buying longer-term bonds and shorting Treasuries to balance out any losses from rising rates
Products such as these could be important new drivers of growth in an industry that has experienced a slowdown in new products, according to this article in the Wall Street Journal. And that could explain why more companies are planning to launch zero duration ETFs in the next six months—17 are in the works, as many as in the prior three years combined, according to Morningstar.
Any product that can address duration risk is likely to get a lot of attention right now: the same article points out that the price of a fund with a duration of five years would fall 5% if interest rates rose just one percentage point.
Of course, no one understands the dangers of duration risk more than plan sponsors—right now, they’re already looking closely at unconstrained bond funds that give active managers a bigger toolkit to handle interest rate risk.
ETFs that do the same thing could be an interesting product for plans eager to maintain liquidity and manage volatility.
But zero duration bond ETFs aren’t without risks—something that isn’t always evident at first blush. On the cost side, the Wall Street Journal also notes that zero-duration ETFs might come with additional costs that aren’t included in the expense ratio, depending on how a particular product hedges interest rate exposure. And where there’s hedging there can be complexity—plan sponsors must beware and make sure they have a clear handle on a product’s characteristics and return drivers.
Still, at a time when rising rates are a real threat to investors a new suite of products that can tackle liquidity and low costs could be a welcome addition to the landscape.