Why Haven’t Bond ETFs Killed Active Bond Managers?

Today we continue our discussion of US listed exchange traded funds and innovative disruption with a simple question: “Why haven’t fixed income mutual funds seen the same level of asset losses to ETFs as equity mutual funds?” Here’s some summary data that shows the magnitude of the difference:

• Over the last 3 years, equity mutual funds have lost $479.9 billion in assets to ETFs. More than 100% of this loss ($579.7 billion) has come from US mutual funds bleeding assets to domestic equity ETFs.

• Conversely, fixed income mutual funds have seen inflows of $419.3 billion over the last 3 years, with bond ETFs picking up $271.3 billion.

• (Data from the Investment Company Institute and www.xtf.com.)

That’s a remarkable difference given that bond ETFs share all the theoretical advantages of their equity counterparts. They tend to have lower fees than mutual funds, hew to an established index, and provide intraday liquidity. So what’s going on here?

Here are some possible explanations for the disparity and a few observations about what they tell us about innovative disruption generally:

#1. Equity ETFs led fixed income product introductions by almost 10 years.The first-ever US listed ETF was the SPY SPDR S&P 500 product, launched in January 1993. By comparison, the first bond ETFs (3 iShares Treasury products and 1 investment grade corporate fund) launched almost a decade later in July 2002.

The lesson: the wheels of disruption can grind very slowly indeed. Why did it take ETF sponsors so long to introduce bond ETFs? Likely it is because equity products were growing so quickly that they didn’t need to address this market right away. But like Amazon with books, they eventually expanded to these (and other) complementary products.

#2. Equities have crashed twice in the last 20 years; bonds never did. The old saying “never let a crisis go to waste” applies to business as well as politics. Equity investors were forced to consider the costs/benefits of active portfolio management while staring at large drawdowns twice in a generation. Many chose to switch to passive index tracking as a result, and ETFs were a logical choice. Conversely, bonds have been in an almost-non-stop bull market since the early 1980s. That limits the pressure to switch from active management; why fix what isn’t clearly broken?

The lesson: cyclical factors drive the pace of technological disruption much more than entrepreneurs and venture capitalists would ever admit. Airbnb started in 2007, just when American homeowners/renters began to feel the pinch of the Great Recession. Uber hit its stride in 2011, when US unemployment was still 9%. Equity ETFs were just as much “right place, right time” over the last 20 years, offering low-cost transparent indexing to investors seeking equity exposure.

#3. Demographics play a role as well. I started on Wall Street at a mutual fund company in 1984, and the firms’ offerings were primarily equity products. Baby boomers rushed into these funds even with 8% commissions and +3% ongoing fees. The 1980s/1990s stock market boom made those palatable, and most of our clients used a broker rather than investing directly.

I suspect many of the people who bought those funds are still alive and still use a broker. But since they are now 30 years older, their allocations have shifted to fixed income from equity mutual funds. Exchange traded funds don’t pay 12B-1 fees (mutual funds still do), so there is an incentive for the broker (whose fees have been squeezed everywhere) to recommend these products.

The lesson: disruption works best when it targets the low end of a market first (like S&P 500 indexing or online book sales). That does, however, leave the existing market to run its course, especially in an industry like money management where the best customers are usually older. The next generation – milllennials – are starting their investment programs with ETFs (primarily equity funds). Eventually they will be larger buyers of bond ETFs, but that is some time away.

Final thought: while very few finance professionals think of ETFs as “innovative disruption” on par with the Internet or mobile smartphones, the truth is their growth follows exactly the same playbook. That makes them an important case study, since they show precisely how the process works. As you look at the current leading edge of Tech-based disruption – AI, autonomous vehicles, whatever – that’s a very useful paradigm to keep in mind.