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Fixed income ETFs or futures: the big debate

WITH a sovereign debt crisis threatening to bubble over and corporate bonds regaining their popularity as companies strengthen their balance sheets, fixed income has once again returned to the forefront of investors’ minds as an alternative trade to equities.

Traditionally, traders would turn either to the futures markets or to fixed income funds as a way of gaining exposure to the bond markets but fixed income exchange-traded funds (ETFs) have been steadily growing in popularity since they were first introduced in 2005. The range on offer has since widened substantially. Net flows into fixed income ETFs in the week ending 7 May totalled €423m, mainly driven by €472m flowing into money-market funds. Fixed income assets under management have risen 8.2 per cent year-to-date.

But although ETFs are now more widely used by both institutional and retail investors to gain exposure to the fixed income markets, traders need to choose the product that is right for their circumstances and understand the difference between futures and ETFs.

“The futures market works for those investors who want short-term leverage and it is much easier to short a futures contract than it is to go short on an ETF,” says Nizam Hamid, head of sales strategy at BlackRock’s iShares, an issuer of ETFs.

But for the trader looking simply for diversified, long-term exposure to the fixed income markets, buying exchange-traded funds can offer plenty of advantages over trading actual futures.

First, there are only a limited number of liquid futures contracts on the European bond markets and they are only on certain German or UK government bonds. ETFs, on the other hand, can offer exposure to a broad spectrum of Eurozone bonds. Second, futures only offer the investor limited yield curve exposure as a future is based on only one bond whereas fixed income ETFs will typically have underlying securities that are more widely distributed along the yield curve. Both these factors mean that it is harder for investors to diversify and manage their risk profile through a futures contract.

Third, investors who are concerned about transparency – many bonds are still traded over-the-counter – can benefit from ETFs which are listed on an exchange and so provide a greater degree of visibility and transparency.

Cost is also an issue. Futures are well known for being a low cost trading product – the rolling of government bond futures contracts costs less than one basis point whereas traders using ETFs will have to pay a management fee, typically between 0.15 and 0.20 per cent per year for fixed income ETFs.

But once you take into account the potential tracking errors of futures and ETFs, then ETFs start to look more attractive, especially over the medium to long run. The total expense ratio (TER) of db x-trackers’ iBoxx Euro Sovereigns Eurozone 10-15 TR Index is just 0.15 per cent per annum. It is reckoned that futures contracts cost around 1.12 per cent per annum, due mostly to the estimated tracking error and the cost of rolling your position.

However, while ETFs might appear to come out on top, traders looking to do anything other than go long on fixed income products will find that futures are generally more appropriate.

Choose your trading style first and then select a product that suits it.