A strategic framework for portfolio construction
Active fixed income ETFs come in many shapes and sizes, from portfolios focused on global rates markets, to strategies that target higher returns from high yield or emerging market bonds. The key to building resilient active fixed income ETF portfolios is to achieve the right mix of strategies based on individual return targets and risk appetites.
Our strategic framework for portfolio construction groups active fixed income ETFs into three categories based on the role they can play in a diversified portfolio: Core Holdings, Core Complement and Yield Enhancement. The framework is designed to simplify the different types of active fixed income ETFs available and illustrate how each category contributes to a diversified portfolio.
Core Holdings typically provide exposure to high quality securities issued by either governments or companies, or aggregate portfolios of investment grade
bonds, offering lower volatility returns and effective diversification to equity holdings. Their role is to act as the stabiliser at the core of a portfolio.
Ultra-short duration bond ETFs form the Core Complement category. These active fixed income ETFs are designed to target a yield pickup over cash while staying anchored to the role of ballast and consistency. In this way, they can help improve a portfolio’s carry (the return earned from income and roll-down by holding bonds over time) by moving up the yield curve from cash without significantly increasing risk.
Finally, Yield Enhancement ETFs target a higher income and yield compared to the core sections of the pyramid. Depending on your risk budget, this is where you’ll find the spread sector and higher carry strategies that are not just driven by interest rate risk, but also by credit risk, liquidity and optionality (which is the ability of borrowers to prepay or extend the maturities on some bonds).
Tactical portfolio allocations
How much of a portfolio is allocated to each category in the Active Fixed Income ETF Framework will be influenced by the prevailing economic environment and the outlook for interest rates.
To illustrate, our Rate Regime Playbook provides practical examples of how portfolios may allocate to ETFs in different economic scenarios, based on our strategic framework, and how these allocations may evolve as the macro and rates backdrop changes.
While these allocations are not prescriptive and are not to be taken as one-size-fits-all investment advice, they do serve as a reminder of how different fixed income strategies can be deployed depending on whether interest rates are falling, range-bound, or rising. The key point, however, is that the portfolio structure remains consistent, even as allocations change, helping to build resilience across different economic regimes.
Falling rates
In a slow-growth or recessionary environment, where falling interest rates are pushing bond yields lower, a typical strategy is to use bonds to provide both income and return protection by deploying cash into fixed income, extending duration and enhancing yield.
In this scenario, active fixed income ETFs in the Core Complement category can help investors boost income by locking in yields for longer as rates fall. But longer-dated bonds have greater potential for gains as rates fall, so investors may look to extend duration and enhance yield through a higher allocation to Core fixed income ETFs. Credit spreads would be expected to widen as economic growth falters, so exposure to Yield Enhancement ETFs at the top of the pyramid would typically be selective and focused on higher quality strategies.
Range-bound rates
In a range-bound environment, where interest rates and bond yields move within a tight band, a typical strategy is to keep fixed income allocations positioned to provide a steady income. This means maintaining a balanced portfolio where carry and income do the heavy lifting.
In this scenario, active fixed income ETFs in the Core Complement category can help investors generate income while staying broadly diversified and avoiding large directional rate bets. Because gains from falling rates are likely to be less pronounced, investors may prefer to keep duration closer to neutral and focus more on sector and security selection in extended sectors to boost returns, via Yield Enhancement ETFs at the top of the pyramid.
Rising rates
In a rising rate environment, the playbook shifts towards a reduction in portfolio rate sensitivity by shortening duration and/or by trimming exposure to Core ETFs. At same time, Core Complement allocations may be increased to maintain income generation without taking unnecessary duration risk.
In this scenario, active fixed income ETFs in the Core Complement category can help investors stay invested in fixed income by emphasising shorter-maturity, lower duration approaches that are designed to be more resilient as yields rise.
At the same time, if rates are rising against a strong growth backdrop, Yield Enhancement allocations may be increased to provide access to more “equity-sensitive” areas of the bond market, such as high yield.
Aligning active fixed income ETFs to risk budgets and portfolio roles
Our portfolio construction framework, together with the illustrative allocations provided by the Rate Regime Playbook, is intended as a guide rather than a prescriptive allocation model. However, it does provide an understanding of how the different building blocks are positioned across the risk and yield spectrum, which can help investors construct an effective active fixed income ETF portfolio that is aligned with their investment objectives and risk budgets.
We’ve used five of our flagship active fixed income ETFs to illustrate how the framework can be applied by an asset allocator to construct portfolios for different market environments. Together, these active strategies, which are all based on time-tested investment processes that have been refined for more than a decade, provide broad exposure across core government bonds, investment grade credit, high yield and emerging market debt.
Using these ETFs, we’ve built illustrative model portfolios that are positioned to work in two economic scenarios: rising rates or falling rates. Portfolio A is built for a rising rates environment, which is typically characterised by above-trend growth and inflation. In this scenario, higher allocations to emerging market debt and corporate credit can create a portfolio that has a higher sensitivity to strong economic growth and the potential to yield higher levels of income compared to a core-heavy allocation. As such, Portfolio A is tilted towards higher yielding fixed income assets, with 70% allocated across our JPM Global IG Corporate Bond Active UCITS ETF, JPM US High Yield Bond Active UCITS ETF and JPM Emerging Markets Local Currency Bond Active UCITS ETF.
In falling rate environments, when growth slows and central banks cut rates, an allocation to core ETFs, such as our JPM Global Government Bond Active UCITS ETF and JPM Global Aggregate Bond Active UCITS ETF, may provide investors with the opportunity to benefit from declining yields while helping to cushion equity market volatility. Portfolio B illustrates this approach, with more than 65% allocated to these core strategies, and less than 10% invested to higher yielding ETFs.
What both scenarios demonstrate is that actively managed fixed income ETFs can provide asset allocators with a liquid, cost-effective toolkit for constructing portfolios that reflect different market environments and investment objectives.