Many investors are making new allocations to fixed income using exchange-traded funds (ETFs). That’s not surprising given the advertised benefits of ETFs, including cost-effectiveness, tax efficiency, liquidity, and real-time pricing. Bond investors have been eager to harness any potential advantages, particularly after such a difficult year across financial markets.
Nevertheless, most of these new fund flows into fixed income ETFs are still heavily skewed towards passive approaches—simply mirroring established benchmarks. We think that’s leaving some of the potential benefits on the table, so to speak. Why should investors settle for whatever an index deals them just to take advantage of an attractive ETF wrapper? Rather than settling for passive, we believe investors should target actively managed bond ETFs to gain the right fixed income exposure.
Here are three reasons why our team favors actively managed ETFs for fixed income investors:
- Consider some of the inherent limitations of passive fixed income investing. For starters, the nature of a bond index can and does change over time, often with investors blissfully unaware. That’s not always a good thing as the changes can markedly alter the risk profile of an investment that investors may have been hoping to set-and-forget. A perfect example is the Bloomberg US Aggregate Bond Index (the Agg), which is probably the most popular benchmark for the investment-grade, US taxable bond market. The duration of the Agg—duration is a measure of interest rate sensitivity—increased from just under five years to almost seven years over the past decade. In fact, the Agg had a duration of 6.8 at year-end December 2021, the very time of the Federal Reserve’s most recent policy pivot. Thus, right before a sharp move higher in rates, any investor in a passive ETF that tracked the Agg was taking on greater interest rate risk than probably intended.
- It’s not just the fickle nature of the index. It’s important to remember that an index like the Agg includes 10,000+ securities, including some that are relatively illiquid. Recreating it is no easy task. Do you really need a portfolio of 10,000 bonds to achieve proper diversification benefits? Not likely. An active approach should be able to create a diversified portfolio more may efficiently and without being tied to an index’s oft-mercurial asset mix. The ability to tilt a portfolio toward a manager’s preferred asset type or sector can also be a valuable risk-mitigation feature that should not be overlooked.
- Another important factor to consider is the very nature of the fixed income universe, which is expansive and incredibly diverse. Bonds trade via broker-dealer networks, as opposed to a transparent listed exchange (as equities do). The takeaway here is that such dynamics naturally lead to an information differential among participants in the fixed income market, which can be used by savvy active managers and their teams of credit analysts. This is also true when it comes to getting access to attractive new issuances, which are available to some, but not all, market participants. An actively managed approach to fixed income—one that uses independent credit research to identify relative value, maintain diversification, and manage risk—should be able to add incremental value versus an index, in our opinion.
Fixed income ETFs are having a moment, and we see no reason why they won’t continue attracting flows going forward. But it’s important to reiterate that investors don’t need to settle for passive when it comes to fixed income ETFs. We prefer the odds of our actively managed approach.
By James Jackson, CFA, Victory Capital