Prudent Active ETF Strategies That Can Adapt to Changing Environments

As the U.S. nears a turning point in a three-decade long rally in the fixed-income market that pushed yields to record lows, bond investors may consider actively managed exchange traded funds that can better navigate changing conditions ahead.

On the recent webcast, ETF Active Management: How You Can be a Part of its Success, Dave Mazza, Head of ETF & Mutual Fund Research at State Street Global Advisors, outlined the potential drawbacks of investing in a broad bond market index strategy today.

Mazza argued that given the monthly coupon and price return, the benchmark Barclays US Aggregate Bond Index has little room to return more than its yield to maturity of 1.9%. Moreover, with a low yield, the potential for income generation from a ore allocation to the benchmark bond index is equally as low.

“The yield on the Barclays US Aggregate Bond Index is 60% below its long-term average,” Mazza said.

Meanwhile, investors are exposed to greater risks. Mazza pointed out that as yield has fallen, the Barclays US Aggregate Bond Index’s duration has increased – duration is a measure of a bond portfolio’s sensitivity to changes in interest rates, so a higher duration corresponds with greater rate risks. Specifically, the benchmark index includes about an 80% allocation toward rate sensitive sectors, including Treasuries, government-related debt and securitized debt.

David Haviland, Portfolio Manager and Managing Partner of Beaumont Capital Management, warned of the damaging effects of rising interest rates on fixed-income assets. For instance, looking at maximum drawdowns between 1973 through 2015, Haviland found that high-yield and convertible bonds have been among the worst performers during bearish conditions while U.S. 10-year bonds and foreign 10-year bonds held up better, or at least have not done as poorly.

Consequently, bond investors who still want to hold onto fixed-income assets in a rising interest rate environment ahead may consider actively managed strategies that are able to quickly modify holdings to adjust to a changing environment.

“Actively management helps managers proficiently managed risk,” Marc Pfeffer, Senior Portfolio Manager at CLS Investments, said. “The unconstrained ability to reduce or terminate exposure to asset classes with heightened levels of risk and allocate to more favorable asset classes better benefits the investor over time.”