The latest venture to enter the European ETF scene features some very familiar faces. Tabula is a new provider of fixed-income ETFs and it is led by Michael John (‘MJ’) Lytle, formerly one of the founding partners behind Source which was acquired by Invesco last year.
Along with Hasan Sabri, who was previously the chief operating officer at Moneyfarm and before that the same role at GLG Partners, Lytle hopes to leverage the pair’s entrepreneurial expertise to provide what they claim will be “precise and practical tools” for fixed income portfolio construction.
The first fund launch is yet to be announced but it will be aimed at the investment grade credit before more funds emerge to cover the entire fixed income spectrum from high yield to inflation, government debt and emerging markets.
Ahead of these launches, ETF Stream took the opportunity to talk to Lytle about his plans for the company and about why now is a good time to be launching a fixed income focused ETF provider. There are after all, as he says, some “very good macro dynamics around fixed income.”
“From a focus and flow perspective, the money going into passive fixed income – mainly ETFs – has been accelerating over the course of the last few years,” he says.
As he points out, the percentage of the ETF market that is now fixed income has risen from sub-20 percent five years ago and is now closer to 30 percent. This is a reflection of the fact that multi-asset investors want fixed-income exposure and they are finding that ETF structures are the easiest way to buy into the market.
The trend from active to passive “has been the whole story in the equity space” but in fixed income the percentage of assets managed in passive strategies is currently unlikely to be over 5 percent. “It’s on a completely different scale,” he says.
The reason for the lag here is down to a number of factors, including the basic fact that ETFs are trading products but also because the concept of beta in equity is much better defined.
“There is no fundamental question as to whether an equity market cap weighted index is representative of the market. People may question whether you want to be market cap weighted because it may over-emphasise momentum as a factor, but they don’t dispute that the largest companies by market cap also dominate revenues and profit,” he says.
“In fixed income, the basic question of whether the index is a good representation of fixed income is a pertinent question. The largest benchmarks, which often track 3,000-8,000 bonds, capture a wide range of issuers based on who found the European debt markets attractive compared to other sources of funding. You can ask some fundamental questions about whether you are getting exposure to the right entities, weightings and payoff profiles.”
The risk game
A key element of market risk in fixed rate bonds is interest rate risk. “In the credit space, analysing the risk and reward of investing in various credits comes down to the trade off between credit spread and default rates. You are trying to pick companies that will pay back their debt more reliably than their predicted default rate,” he says.
“That relationship over the past 40 years has – except for three years in the late 1980s – been in the favour of the investor. But if you buy fixed rate bonds, you are purchasing interest rate exposure and arguably more interest rate exposure than credit risk. When you are at the lowest point in a 40-year interest rate cycle, you can be right about the quality of the credits you are buying but still lose money due to interest rates going against you.”
In this way, he says, you will need to disaggregate the various factors within credit investments to “hone in on the element of credit investing that you as an investor are interested in.”
This is something that experienced credit investors do every day but can difficult to unpick as a multi-asset investor. So, in other words, it’s a great time to be a specialist, and a great time to parlay that experience into a fixed income fund.
There are also fewer managers focused on passive fixed income. “In equities there are 50 to 60 equity ETF providers whereas in fixed income there are only 15 providers and the top 10 have 98% of the assets.”
Assets under management in fixed income ETFs are even more top heavy with Deutsche Bank, BlackRock and Lyxor dominating the market. “Although there are 400 fixed income ETFs most of the asset are concentrated in the top 40 funds. Issuers have tried to innovate but, in general, few new funds have resonated with investors. The fires of competition need to be stoked.”
Tabula will be working with IHS Markit on the initial indices that it’s funds will track. At the same time, Tabula is an authorised representative of Cheyne Capital until it gets its standalone FCA authorisation. Tabula’s emergence confirms that the ETF scene is booming, with both new suppliers and new ideas; ETF Stream has written recently about HanETF and market√üeta, confirming it as one of the busiest sectors in the investment world.
Beyond his desire to get Tabula in front of investors, Lytle also thinks that the fixed income asset class deserves more publicity. “Fixed income could do with more media exposure”, he suggests.
“Compared to equity, fixed income gets very little coverage,” he says. “This is because fixed income is a more technical asset. Investment outcomes can be modelled and calculated. That is boring for people. In contrast, in equity, there is no absolute determinant of value. Equities are all about stories and relative value. Two analysts can disagree vehemently about the correct value for a share.”
Of course, this isn’t to say that the debate about interest rates isn’t high-profile. The Fed seems to be on a path to higher rates and Fed watching is a sport in itself. Despite the more dovish comments in recent Fed meeting notes, most pundits are certain we are on a path to steadily more tightening and the resulting impact on the interest rate yield curve.
However, the importance of these moves to the investment grade corporate sector is more nuanced.
“What we have seen, from an interest rate perspective, is that the dollar turned a corner about a year ago,” he says. “The highest point in rates was 1980 – when the US Prime Rate hit 21.50%. Since then rates fell towards zero with the first Fed rate hike since the credit crisis arriving in December 2015. In one form or another, if we believe central banks and economists, rates are on their way up. But unlike the past interest rate cycles where the US tended to raise rates very rapidly in a relatively short period, this looks like a much more gradual rise in rates.”
Credit spreads differ from underlying interest rates in two fundamental ways. First, they have been less directional over the last four decades. They oscillate with corporate leverage ratios and economic fundamentals. Second, the range of average investment grade spreads is much smaller.
“Interest rates and credit spreads are very different and react to different perceptions of risk. Investment grade credit spreads reflect the absolute and relative perception of corporate credit quality and, ultimately, how likely investment grade credit are to default. The range that average investment grade spreads have covered in the last 40 years is significantly narrower than the underlying interest rates.”
Lytle believes that there is more that enough room for passive and active managers to co-exist. The complexity of fixed income investing means that active fixed income managers will continue to see strong demand from investors. Nonetheless, the game of numbers means that “in a market that is 95 percent active and five percent passive there is definitely more demand to come for passive.”
“I don’t need to change anyone’s behaviour,” he says. “I simply need to talk to the people that have already made a decision but recognise that existing products only address a few of their investment needs.”