A few reasons why many financial advisors love bond ETFs

Matt and Karen break down the findings on bond ETFs from the most recent Cerulli report, and chat about where the asset class might be headed in the future.

I have talked a bit in the past about the growth of the bond exchange-traded fund (ETF) market. In 2017 over $60 billion has flowed into the asset class, trading volumes are over $5 billion per day on average, and more and more investors are finding ways to use bond ETFs within their portfolios (Source: Bloomberg as of 6/15/17).

But why? Investors have had access to bonds and mutual funds for years. What is it about bond ETFs that has led to their popularity? We think we know some of the reasons why, as narrated in this video. But what’s more, Cerulli Associates, an independent market research firm that specializes in asset management analytics, recently published an in-depth research piece on just this topic. To help break down the findings, I talk to my colleague Karen Schenone, who is an expert in fixed income markets and ETFs. Karen regularly talks with financial advisors and knows a lot about how they use ETFs and how they invest in the bond market.

Matt: What is the Cerulli survey and what does it cover?

Karen: We at BlackRock have been working with financial advisors since the first bond ETF debuted in 2002, and Cerulli’s report, Bond ETFs: Financial Advisors Drive Use with Specialized Applications, has some great usage data that supports things we have learned, and points to a couple of things that were new to us. Cerulli surveyed 378 financial advisors in the U.S. to find out how and why they are using bond ETFs in their client’s portfolios, and what they see as future trends in the industry.

Same benefits, new asset class

Matt: What are some of the report’s big takeaways?

Karen: There are quite a few, but to me the biggest one is financial advisors are realizing bond ETFs are as useful as equity ETFs. Most advisors got started with ETFs by buying equity or commodity funds. Only 3.5% of advisors bought a bond ETF as their first trade. However, those advisors who are using ETFs have come to recognize that bond ETFs offer many of the same benefits as an equity ETF, including diversification, low fees and ease of exposure. See the chart below.

chart-equity-bonds-v2

Tax efficiency ranked lower as a recognized benefit since most bond ETFs do get taxed on monthly income distributions. But many ETF fund structures help bond ETFs realize and pay out fewer capital gains. Only 8% of iShares bond ETFs paid out capital gains in 2016, compared to over 30% of bond mutual funds. (Source: BlackRock and Morningstar, as of 12/31/16. For the bond mutual funds, we used the average number of bond mutual funds that paid a capital gain distribution each year within a universe of 7,887 funds. Universe includes all U.S. open ended mutual funds with at least a five-year track record excluding money market funds, all share classes used. Past distributions are not indicative of future distributions.)

Interestingly, many advisors who are not currently using bond ETFs say that they would use them if they understand ETF benefits (41.3%) and implementation (31.7%) better.

This is quite different from the equity story. Only 61.8% of advisors said that they were very familiar with bond ETFs, versus 81.1% for equity ETFs.

First move, model portfolios

Matt: The message from the Cerulli report seems pretty obvious: A good number of financial advisors want to start using bond ETFs but don’t know how to go about it. How do most advisors get started?

Karen: It’s true that advisors moving from transaction oriented practices to an advisory model might need a roadmap to help build portfolios. The study found that 55.9% of advisors surveyed get started by using model portfolios from home office models, third parties or ETF sponsors. These models may be an easy and efficient way for advisors to start incorporating bond ETFs into advisory portfolios.

Zero-sum game

Matt: With the inflow into bond ETFs, where is the money coming out of?

Karen: The Department of Labor (DOL) Fiduciary Rule plays a role here. As you pointed out earlier, the inflow so far in 2017 has been significant, and according to data on net new assets, the flows into bond ETFs this year are on pace to exceed last year. (Source: Bloomberg and BlackRock, as of 5/30/17. Net new assets are across all ETF providers. We compared the numbers from the first five months of 2016 and 2017.) Almost 36% of advisors surveyed thought the DOL Fiduciary Rule would contribute to an increase in bond ETF usage. The survey showed that most advisors, especially larger advisory teams with a Chief Investment Officer (CIO) function, are sourcing the money they direct to bond ETFs from individual securities and even mutual funds. This trend is supported by advisors’ answers on future usage: 50.2% said they planned to use more bond ETFs while only 11.8% responded with the opposite. By contrast, advisors said they would likely use less of individual bonds and bond mutual funds. See the accompanying chart.

chart-product-v2

Bond ETFs are being used by many financial advisors for core fixed income exposure, as well as more specialized applications such as managing duration and seeking income. It is clear from the Cerulli survey that bond ETFs are important portfolio tools, and that they can help advisors reach a variety of investment objectives. It’s really up to us—fund sponsors and industry participants—to continue with more bond ETF education to help advisors understand the benefits we talked about here today, and understand how they can use bond ETFs across the portfolios they manage.

Matt: Thank you, Karen. You can read more details on the Cerulli study and its findings here. If you are looking to get started with bond ETFs, consider a broad fund like iShares Core U.S. Aggregate Bond ETF (AGG) or iShares Core Total USD Bond Market ETF (IUSB). If you are more interested in building a custom portfolio, the Core Builder Tool on iShares.com can help.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog. Karen Schenone, CFA, is a Fixed Income Product Strategist and contributed to this post.

Learn more about how consistent investment performance and low fees are critical to achieving your fixed income goals in today’s environment.

Cerulli Associates conducted an online survey of 378 financial advisors in December 2016 and January 2017 to ask them about their practices and specifically their use of bond ETFs. Respondents needed to manage at least $50 million in assets and take discretion over at least half of client assets. Respondents are diversified among business models (wirehouse, independent B/D, registered investment advisor, etc.). The original distribution of respondents has been weighted to reflect Cerulli’s overall sizing of the financial advisor marketplace. This study was sponsored by BlackRock. Figures used with permission.

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Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

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