We are seeing an increasing role for actively managed bond ETFs as they may provide regular income in addition to portfolio diversification.
Fixed income ETFs have attracted strong flows1 in recent years as investors navigated rising yields and market uncertainty. Now, the shift to active fixed ETFs is gaining traction with investors seeking to source returns in an increasingly complex market environment.
Harnessing active strategies in fixed income
ETFs have become popular vehicles to house core fixed income exposure, such as a diversified bond index, at relatively lower cost. The vehicle of choice so far has predominantly been passive ETFs but we are seeing an increasing role for actively managed bond ETFs as they may bring portfolio diversification and potential return enhancements. This is especially true in an uncertain market environment, such as now, where active ETFs have the opportunity to offset the changing investment characteristics of fixed income indices and market behavior by allocating to quality bonds that exhibit the most value.
Active ETFs may diversify portfolios and drive return potential…
Cap-weighted bond indices, which passive strategies track, have some well-documented limitations.
First, they give the greatest weight to issuers with the greatest amount of debt. So passive ETFs will – by default – be more concentrated in the most indebted issuers. An actively managed fixed income ETF is backed by rigorous credit research. Therefore it has the ability to allocate towards the higher-quality issuers and away from those that could be at risk for downgrades, which may help preserve capital and returns in time of economic or market stress.
Even ETFs that track a fixed income index will have to take active investment decisions as broad bond indices count thousands of securities as constituents. Therefore it becomes complex and expensive for ETFs to include all securities in an index. The passive ETF issuers typically decide on security selection on the basis of ensuring a low tracking error rather than from a risk management or return perspective, as is the case with active ETFs.
Active fixed income ETFs may also capitalise on numerous factors that impact bond prices and move markets, including economic and market cycle. Besides, central bank actions and regulations may distort bond valuation as they are designed to achieve policy objectives. An active strategy may adjust interest rate exposure and sector allocation through the cycle and away from market distortions, potentially enabling investors to own undervalued securities and underweight expensive ones while minimizing volatility.
…all this with the transparency and liquidity benefits of passive ETFs
Active ETFs provide daily transparency into underlying holdings versus monthly or quarterly for mutual funds. They are usually also highly liquid as they tend to have the same primary market mechanism as passive ETFs. They trade on the same stock exchanges in the secondary market, which allows investors to buy and sell throughout the day with real-time price discovery. This also allows investors to monitor the values of their active portfolios more closely, a material benefit in times of market stress.