Fixed Income ETFs? The Shorter, the Better

Fixed-income exchange-traded funds have made big strides in asset gathering over the past five years, rising from $53.7 billion in 2008 to $229.1 billion by March of 2013, according to Lipper.

At the top of the heap sit high-yield funds with $32.5 billion in assets under management, followed by intermediate investment grade debt funds ($31.6 billion), inflation-protected bond funds ($28.3 billion), corporate debt funds BBB-rated ($26.8 billion) and rounding out the top five, flexible income funds ($15.1 billion).

Earlier this month, Charles Schwab & Co. ETF experts addressed trends in fixed-income ETFs as well as a broad discussion on the way the asset waves are flowing overall on Schwab's platform in their Every Third Friday webinar.

The question that hangs over many investors is the Federal Reserve's intentions regarding quantitative easing. According to recently released minutes from the Fed, Fed members think the central bank should continue buying $85 billion in Treasuries and mortgage-backed securities a month, at least through midyear to lower long-term interest rates.

Schwab's ETF business has benefitted from investors' jitters, especially when it comes to bank loans and floating rate products. "We've seen several trends in client segments that stand out to us," says Jackie Chin, managing director of the ETF platform at Charles Schwab.

"With retail traders, fixed-income ETF flows were negative overall. We saw floating rate fixed income ETFs gather about 30% of the flows from retail investors. This is significantly more than we've seen with our other clients. Retail investors tended to favor high yield in corporate fixed income ETFs instead."

Schwab's RIA clients shunned government fixed income products while putting their dollars in bank loan products. "With our RIA clients, we saw significant flows into bank loans in convertible ETFs; this was 27% of the fixed income flows. RIA clients backed away from government ETFs and we saw large outflows in these. We can likely speculate this is due to the low interest rate environment," Chin says.

And RIAs' moves into bank loan ETF products points to a bigger trend of investors trying to get ahead of a possible change in Fed policy. "If you think back a couple of months ago, things were looking a little stronger and the Fed was starting to talk about dialing back on quantitative easing," says Schwab's fixed income strategist, Kathy Jones. "We think that that's probably a little bit early, and that there's going to be a long wait for this to happen."

Investors are also looking for income sooner rather than later. "Another area we're seeing a shift is in shorter duration fixed income ETFs," says Chin. "At Schwab if you look at ETFs with short and ultra-short duration, these represent the vast majority of the flows in fixed income in Q1. A year ago, we saw ETFs with broad maturity dominating these flows."

Investors also seem to be taking a more lax attitude towards inflation concerns, "Lastly, I would like to highlight inflation-protected ETFs, many clients were trading out of this in Q1, likely because of the reduced concerns of inflation," Chin says.

Jones echoed Chin's observations on investors' penchant for shorter-maturity fixed-income ETFs. "People are looking for yields without trying to extend durations," she says.

"Investors want more yield but they don't want to take the risk of long maturity. It's always a good time for fixed income,'' Jones said. "Every portfolio needs some funds in it. Our advice has been to limit the exposure on the duration side, not take too much duration risk. Not that we're looking for rates to go up, we just don't think the risk reward is all that attractive in longer maturity."

All told, Chin says it was a really a good quarter for Charles Schwab with total assets on its ETF platform accruing to $168 billion at the end of the first quarter, up 11% from the fourth quarter in 2012. "We experienced record flows across all of the segments," she says.

On the fixed-income front, Chin says the firm is seeing more dramatic shifts between strategies as clients appear to be trading fixed-income ETFs more tactically. "We're seeing big swings quarter-over-quarter. The high-yield ETFs turned positive in Q1, having seen huge outflows in the prior quarter. Conversely, emerging markets and government fixed-income products both went out of favor in Q1, but were positive in Q4."

On the equity front, international equity ETFs captured 35% of flows, driven by interest in China and Japan ETFs, according to Chin. Sector ETFs, which had a really strong year in 2012, leveled off as the year progressed. But they came back strong in the first quarter, led by the financial, global real estate and energy sectors, according to Schwab.

Schwab's ETF platform flows came mainly from retail traders (defined by Schwab as traders that trade with them at least 36 times a year), who represent about 5% of the twelve month ETF flows, with the remaining 95% split evenly between retail investors and Registered Investment Advisor clients with 47% and 48%, respectively, according to Chin.

Schwab's retail traders, investors and RIAs tended to diverge on which fixed-income products they put their assets into. While retail traders were not keen on fixed-income ETFs in the first quarter, retail investors poured money into floating-rate and high-yield products.

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Fixed income ETFs
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