Why Bond Investors Should Look Beyond Index ETFs

Passive, index-based bond exchange traded funds have helped investors ride the bull rally in fixed-income assets in recent years, but changing market conditions will have to force them to reconsider their investment options.

At the Inside ETFs Canada conference in Montreal, Patrick O’Connor, head of global exchange-traded funds at Franklin Templeton Investments, argued that fixed-income indices are “broken” and active management will become necessary for successful bond ETFs, reports Kristine Owram for Financial Advisors.

“Investors typically have gone into passive fixed income primarily because that’s all there was,” O’Connor said. “But as a firm, and as an active manager, we don’t just think indexes are flawed in fixed income, we think they’re broken.”

Related: BlackRock Strategist Locating Opportunities in Fixed Income

Bond Index ETF Weights

Traditional, market capitalization-weighted bond index ETFs weight individual securities by debt issued, so the most indebted issuer or those that issue more debt will have a higher weight. For instance, in the benchmark Bloomberg Barclays Aggregate Bond Index, government debt, especially U.S. Treasuries, has dominated the portfolio.

“That doesn’t necessarily mean they’re the best companies, but they would be the ones that a passive manager would have to overweight,” O’Connor said.

Furthermore, passive bond ETFs’ underlying indices often add securities when the debt is upgraded and prices rise and remove securities when the debt is downgraded and prices fall, Don Suskind, head of the ETF strategy team at Pacific Investment Management Co, said.