Most of the indices used to underpin fixed income ETFs have inherent problems around pricing, weightings and selection criteria, according to Morningstar.
Jose Garcia-Zarate, an analyst at Morningstar, says a lot of work has been done on index construction, but providers are still faced with many issues.
The fixed income portion of the European ETF market has expanded rapidly over the past two years, growing assets by 45% according to BlackRock figures. Garcia-Zarate says that has more to do with the economic crisis than any improvement in underlying benchmarks.
He says: "Fixed income ETFs took their time to gain traction and in my view one of the reasons for this was the indices being used had a number of imperfections. Many, particularly the broad ones covering a whole market, were not created for trading purposes."
Fixed income indices suffer from tracking an opaque market, where most trading is conducted over the counter and pricing levels are obscured.
There are questions over the best way to weight constituent securities, as the traditional reliance on market capitalisation can create a bias towards the most heavily weighted countries or companies.
Many indices also adopt restrictive ratings criteria, excluding non-investment grade bonds, which Garcia-Zarate says can lead to missed opportunities. He adds: "Active managers can exploit these inefficiencies and generate value."
Recent innovations, however, suggest ETF providers are working to address these issues.
The latest launch from the Pimco Source partnership included a European government bond ETF that utilises a GDP-weighted methodology.
Garcia-Zarate hails the evolution of more targeted products, including ETFs that offer exposure to a particular slice of the maturity spectrum of a class of bond. He adds: "The geographic and sector diversification available within fixed income ETFs really does offer investors a lot of choice."
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