Active fixed income in an ETF wrapper
Active fixed income ETFs can help investors construct strong and cost-effective portfolios
- Fixed income ETFs have experienced tremendous growth in assets, driven largely by passive fixed income strategies, but investors seeking to make use of active ETFs have had limited choices—until now.
- In our view, passive fixed income investing alone cannot create all the outcomes that investors expect from their fixed income allocations: stability, diversification and potential return enhancement. Passive investors are also vulnerable to the changing investment characteristics of fixed income indices and may miss out on the benefits of exposure to securities and sectors that are not represented in a given index.
- Skilled and experienced active managers have the tools to inform security selection, identify return-enhancing opportunities and manage duration and risk—as well as the flexibility to respond to volatile and changing markets.
- Investors should assess how the emerging array of active fixed income ETFs can help them construct strong, cost-effective portfolios.
Fixed income ETFs are transforming debt investing.
Designed to provide a liquid, cost-effective and efficient way to build and manage diversified fixed income portfolios, these funds have been accumulating assets at an impressive pace. Currently, the majority of these vehicles offer only a passive investment style—but that dynamic is changing.
We believe the full transformational power of fixed income ETFs will become clear as managers begin to exploit the structural advantages of ETF wrappers to package skillfully designed active fixed income strategies.
For investors, the benefits could be far-reaching. The unique mechanics of ETFs have the potential to revolutionize the delivery of active fixed income strategies. Investors stand to profit from daily transparency into fund portfolios, lower overall management fees and reduced cash drag. Exchange trading provides investors with enhanced price discovery and greater intraday liquidity—a material benefit in times of market stress.
But why should investors consider active management for their fixed income exposures in the first place?
Time for active fixed income?
In our view, passive fixed income strategies have their uses, but on their own they may not lead to all the outcomes that investors traditionally expect from their fixed income allocations: portfolio stabilization, diversification and enhanced returns. Investors appear to agree, as actively managed strategies still account for 69% of assets in fixed income mutual funds and ETFs.1 The potential unwinding of quantitative easing (QE) programs coupled with elevated market volatility globally will likely make active, flexible decision-making even more critical to portfolio performance in a changing economic environment.
Active strategies enhance returns and liquidity
Active fixed income management has shown its ability to deliver excess returns net of fees—a fact that may surprise some staunch advocates of passive investing. Within each of the three largest bond fund categories, the majority of active funds have outperformed the biggest comparable passive ETF over time; the average return across actively managed funds in each category has also generally exceeded the return of the largest comparable passive ETF (Exhibit 1).
Within the largest fixed income fund categories, active management has demonstrated its ability to add value
Exhibit 1: Active fixed income manager excess returns net of fees vs. Largest debt-weighted ETF by category—average excess returns (%) and percentage of managers outperforming
As an added benefit, active fixed income ETFs provide enhanced access to liquidity. Unlike actively managed mutual funds, ETFs trade on the secondary market, giving investors the ability to buy and sell throughout the day. In addition, by virtue of this trading, the ETF vehicle provides investors with real time price discovery on the value of their portfolios, allowing investors to see how their risk profiles may be changing.
The diversity of the investor base for active fixed income ETFs also supports the liquidity of the product: Not all owners of an ETF are sellers at the same time. Investors can gain exposure to active fixed income ETFs through long and short positions or by buying and selling options, all of which help reinforce the liquidity of the ETF market.
Passive bond investing has limitations
Fixed income ETFs have seen extraordinary growth over the past decade, expanding from less than USD150 billion in 2010 to nearly USD1.1 trillion2 in assets under management (AUM) by the end of 2020—and that figure is expected to exceed that record total by the end of this year. Given regulatory constraints on active ETF issuance prior to 2013, passive strategies have driven this growth—and now represent approximately 90% of fixed income ETF assets.3 But passive fixed income strategies may not deliver the full range of portfolio stabilization, diversification and return enhancement benefits most investors expect to receive from fixed income allocations, irrespective of whether they use an ETF wrapper. To date, however, ETF providers have offered investors only a limited menu of more active solutions.
Indices are not always comprehensive
Unlike comprehensive equity indices such as the CRSP U.S. Total Market Index, which incorporates nearly all publicly traded U.S. stocks, the Bloomberg Barclays US Aggregate Bond Index (colloquially known as “the Agg”) captures only about half of all outstanding U.S. bond market debt.4 Diversified core fixed income investors should be aware that the Agg remains highly concentrated in U.S. Treasury and agency mortgage- backed securities (MBS), which represent nearly 70% of its underlying assets. The index’s rule-based construction, designed in the 1980s, excludes many securities that investors prefer to deploy in a modern, well-diversified portfolio: certain agency mortgage securities, most asset-backed securities and approximately 40% of all corporate bonds.
Investors seeking broader market diversification need to look beyond the rigidity of the Agg for exposure to a more complete set of investment grade opportunities—and access to sectors such as high yield bonds and emerging market debt.5
Passive investors make active decisions
Index investing may not be as passive as investors believe. Structural decisions made within an index with respect to duration, credit quality and security selection can influence the resulting risks and returns in passive funds tracking that index much the same way as taking an active approach.
Over-concentrations of risk are quite common. Most fixed income indices utilized by passive funds, for example, are debt-weighted: The more an entity borrows, the greater its percentage allocation in the index. This is not necessarily a formula for investment success. For example, states such as California and New York, which dominate municipal indices, can skew the exposure of passive bond funds or ETFs with the enormity of their debt issuance. Investors in funds tracking these indices may subsequently end up with disproportionate (and unwanted) exposure to the most highly leveraged and cash-strapped states.
Fixed income indices are subject to sub-optimal changes
The composition of fixed income indices is constantly shifting, driven by—among other things—central bank actions, issuance volume and the maturity of individual debt securities. Over time, such changes can significantly impact the characteristics of an index and the strategies designed to track it, potentially diminishing their suitability in the context of an individual investor’s portfolio.
Investors need to carefully consider how the risk-return profiles of some widely used fixed income indices have changed over time. For example, the Agg—still the most widely used total U.S. bond market index—has become significantly more concentrated in U.S. Treasuries, which offer no credit spread, since the global financial crisis.6,7
Similarly, the Bloomberg US Corporate Bond Index’s sensitivity to changes in interest rates (duration) has increased, from approximately 5.5 years in late 2000 to 8.7 years as of June 2021,8 leaving investors in a precarious position should rates rise. At the same time, the credit quality of the investment grade index has deteriorated: Bonds rated BBB now account for more than half of the index’s market value, up from approximately one-third in the late 2000s. And passive index investors can be captive to potential fallen angels: securities whose value plunges as they fall below investment grade status prior to their removal from the index.
Many investors, however, remain unaware of the limitations of index construction—or of the efforts managers of passive fixed income funds may make to optimize their funds’ alignment and reduce tracking error. The largest passive muni bond ETF, for example, holds just 3,700 of the 12,000 bonds available in its reference index;9 the largest passive high yield bond ETF holds less than 1,000 of the nearly 7,000 bonds available in the high yield universe.10 The more pressing challenge for investors is that the indices themselves may not provide sufficient diversification.
The active difference
Neither active nor passive managers can control fixed income markets or the indices that represent them. But active managers have latitude to navigate trends and opportunities and—most importantly—avoid the over-concentrations of securities that tend to permeate certain indices. Managers with the requisite flexibility, skill and experience can actively address risk expo- sures and take advantage of market dislocations to enhance returns across market cycles. Their tools include:
- Selecting securities and sectors based on information advantages arising from rigorous fundamental credit research.
- Actively managing duration rather than allowing the changing composition of an index to dictate interest rate sensitivity.
- Maintaining a desired level of diversification across sectors by choosing how much (or how little) to invest in securities inside or outside the benchmark.
- Exploiting potential return-enhancing opportunities that arise as yield curves flatten or steepen.
Building stronger portfolios
With the crosscurrents of changing inflation expectations, heightened fiscal spending and probable future rate rises by the Federal Reserve, active fixed income managers continue to see ample opportunities to enhance portfolio returns and mitigate risks.
For investors, however, realizing the potential benefits of active management depends on astute, informed manager selection. In choosing a manager, investors need to focus on those with the global resources and broad sector expertise to deliver superior client outcomes across economic and market cycles, regardless of the type of vehicle or platform. When selecting active fixed income ETFs for their portfolios, investors ought to incorporate many of the same factors they used in selecting managers for active fixed income strategies—and then go further.
Many fixed income investors have embraced the liquidity, cost-effectiveness and efficiency of ETFs. Far too often, though, they have been able to choose from only a limited number of strategies. Now investors have the freedom to assess an expanding array of active approaches as they become more readily available—including core strategies that provide diversification of broad equity exposures, complementary strategies that reduce overall portfolio risk and sector strategies that enhance income and total return. Designed as building blocks for constructing stronger, more cost-effective portfolios, active ETFs hold the potential to transform the future of fixed income investing.
Build stronger fixed income portfolios with J.P. Morgan
We have built and evolved our fixed income capabilities with just one aim: to build stronger portfolios that solve our clients’ needs. Today we are one of the top fixed income managers in the world.
Diverse perspectives, integrated solutions:
- Access the power of a globally integrated team of investment professionals and our proprietary research, encompassing fundamental, quantitative and technical analysis.
- Benefit from actionable insights designed to help you invest with conviction, from our regular macro and market views to our fixed income portfolio construction tools.
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- Tap into the proven success of one of the world’s largest fixed income managers, with broad experience gained across regions and market cycles.
1. ISS Market Intelligence – Strategic Insight’s Simfund; data as of July 31, 2021. Excludes fund of funds.
2. ISS Market Intelligence – Strategic Insight’s Simfund; data as of December 31, 2020. Excludes funds of funds.
3. ISS Market Intelligence – Strategic Insight’s Simfund; data as of July 31, 2021; Excludes fund of funds.
4. “What’s really at the core of your fixed income portfolio?” Portfolio Insights, J.P. Morgan Asset Management, June 2019.
5. Bloomberg Barclays, December 31, 2017.
6. “The US Agg has changed,” J.P. Morgan Asset Management.
7. Treasury securities purchased by the Fed for its QE program were not included in the Agg. But in the absence of a budget surplus, the U.S. Treasury will need to issue new debt to repay those securities as they mature, and that new Treasury supply will be part of the Agg.
8. J.P. Morgan Asset Management; data as of June 30, 2021.
9. S&P Dow Jones Indices, S&P National AMT-Free Municipal Bond Index Factsheet, December 31, 2018; iShares National Muni Bond ETF Factsheet, December 31, 2018.
10. iShares iBoxx $ High Yield Corporate Bond ETF Factsheet, December 31, 2018; IHS Markit, February 4, 2019.
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