The Era of the Bond ETF Is Here

The inflationary pressures shaking Wall Street all year are causing big changes to fixed-income capital flows that could ultimately end up disrupting the money-management industry over the long haul.

Bond investors are increasingly turning to exchange-traded strategies as a way to access the market. This shift has been driven in part by the success of ETFs in the stock market, which has shown the potential of this type of investment.

As volatility increases across asset classes, traders are turning to cheap and easy-to-trade products in order to navigate the bear market of 2022. These products are known for their low cost and easy accessibility, making them ideal for traders looking to take advantage of market conditions.

Unlike mutual funds, which price only once per day at the market close, ETFs behave more like a stock and can change hands throughout the session. This provides a unique advantage when markets are volatile, as it allows investors to take advantage of opportunities as they arise.

According to Sean Collins, chief economist at the Investment Company Institute, the ability to respond immediately to changes announced by the Federal Reserve is one of the advantages of investing in an ETF over a mutual fund.

If the trend of ETFs intensifies, expect to hear loud noises from industry critics who are concerned about the liquidity and systemic risks that these products may create - including distortions in the assets that they track, from stocks to corporate bonds.

As BlackRock Inc. and State Street Corp. battle for market share, an ETF fee war is threatening to rage anew. This would broaden retail access to complex and risky debt trades at a lower cost.

Bond ETFs have been absorbing cash amid a record exodus from mutual funds. This trend is likely to continue, as investors seek out lower-cost, more flexible options.

The Investment Company Institute is a trade association for the mutual fund industry. Bloomberg Intelligence is a research and analysis firm that provides insights on the financial markets.

The switch from mutual funds to ETFs could have a big impact on the markets, with passive strategies becoming more popular. This could lead to criticism that the industry is reducing price discovery in modern markets.

The shift in allocation has been effectively capped by the stickier nature of bond investments and the entrenched role of mutual funds in the pension industry. But how did we get here?

This year, as the Federal Reserve's battle against inflation drives up cross-asset turmoil, a record $446 billion has been withdrawn from US fixed-income mutual funds, according to data from the Investment Company Institute (ICI). About $154 billion has flowed into bond exchange-traded funds (ETFs) instead, even though nearly every fund is in the red.

There seems to be a key difference between the types of investors who use ETFs and those who use traditional mutual funds. Many investors who use ETFs seem to be more interested in short-dated, cash-like products, while those who use traditional mutual funds seem to be more interested in long-term investments.

Mutual funds are popular with long-term investors who are saving for retirement, according to Collins. These investors may have been spooked by the losses, and they are not interested in the ability to trade multiple times per day.

According to Morningstar's Ben Johnson, ETFs are heavily used by financial advisers, which likely helps explain the boom in cash-like ETFs. More generally, these products offer money managers a smart way to hedge portfolio positions or take directional bets on the cheap - a useful tool in this year's volatile and macro-driven market.

According to Johnson, head of client solutions for asset management at Morningstar, the current market conditions are ideal for advisors. In times of market volatility, advisors can reassure their clients by moving some of their assets into investments with higher yields.

The rise of ETFs has been a long-term trend, with investors putting more money into these products than mutual funds for 11 years in a row. However, almost all of this growth is due to equity strategies, which now have over $5 trillion in assets, compared to less than $1 trillion 10 years ago.

Fixed-income mutual funds still hold a much larger share of the market than exchange-traded funds (ETFs). Even after this year’s record withdrawals, data from the Investment Company Institute (ICI) shows that roughly $4.5 trillion was held in old-school bond funds through September, compared to $1.3 trillion in ETFs.

The more-established structure of mutual funds retains a powerful incumbency advantage. For example, the US retirement system and 401(k)s are largely built to integrate mutual funds.

Although the first fixed-income ETFs were launched around two decades ago, the structure was long received skeptically by Wall Street. This is because the funds trade much more frequently than the bonds they hold. However, the Fed’s decision to buy bond ETFs during the throes of the pandemic-fueled turmoil gave the vehicle an implicit stamp of approval. This has helped fuel inflows.

Institutional acceptance of fixed-income ETFs is rapidly growing. Last December, the New York State Department of Financial Services changed its classifications so that insurance companies can now treat fixed-income ETFs as bonds for accounting purposes, instead of as equities. This change could potentially open the door to more adoption of fixed-income ETFs by insurance companies.

One of the factors that BlackRock Inc. cited when predicting that assets in global bond ETFs will reach $5 trillion by the end of the decade was the increasing popularity of ETFs.

Jillian DelSignore, head of advisor sales at fintech platform FLX Networks, argues that transparency is another key driver of the cash flowing to ETFs. ETFs tend to disclose holdings daily, while many mutual funds typically reveal their portfolios just once a quarter. This transparency gives investors a better idea of what they are buying, and helps to build trust in the products.

"You're bringing attention to something that is usually hidden from view," she said. "There's power in that."