[This article appears in our July 2018 issue of ETF Report.]
There are only 225 actively managed funds in a universe of more than 2,100 U.S.-listed ETFs. Not only are more than 80 of those active ETFs classified as fixed-income products, all but two of the top 10 actively managed fixed-income ETFs in terms of assets cover the fixed-income space. Active management is a popular approach when it comes to fixed income, and much of that may have to do with a record of superior performance.
Although research, such as the S&P Indices Vs. Active (SPIVA) report, indicates that most of the time the indexes beat the active managers, that’s not always true. A 2017 research paper from Fidelity Investments using Morningstar data showed that 86% of short-term, 90% of intermediate-term and 94% of multisector actively managed funds beat benchmarks after expenses on a one-year time frame. Over a three-year time frame, the percentages that outperformed benchmarks were 65%, 55% and 65%, respectively. Even on a five-year time frame, well over half of these funds outperformed.
If a fund uses the Bloomberg Barclays US Aggregate Bond Index, such as represented by the iShares Core U.S. Aggregate Bond ETF (AGG), “it’s kind of a low hurdle” to cross, says Ben Johnson, director of global ETF research at Morningstar.
Some of the biggest actively managed ETFs by assets under management (AUM) generally match or beat AGG on a year-to-date basis, including the PIMCO Active Bond ETF (BOND), the SPDR DoubleLine Total Return Tactical ETF (TOTL), the PIMCO Enhanced Short Maturity Active ETF (MINT) and the First Trust Low Duration Opportunities ETF (LMBS).
Even in sectors like high yield or corporate bonds, many active funds beat other passive ETFs often used as benchmarks.
For instance, the Advisor-Shares Peritus High Yield ETF (HYLD) is handily beating the iShares iBoxx USD High Yield Corporate Bond ETF (HYG) year-to-date and on a 12-month basis after fees (although HYG outperforms on a three-year basis after fees). In the corporate bond space, the iShares Interest Rate Hedged Corporate Bond ETF (LQDH) significantly outperforms the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) after fees on a year-to-date, one-year and three-year time frame. However, LQDH is basically an investment in LQD paired with an actively managed hedge, so its outperformance may be more a function of its hedging ability during a period of rising interest rates.
Some Passive Bond ETFs Thriving
Of course, some passive funds are doing well. Take the SPDR Bloomberg Barclays Convertible Securities ETF (CWB), which has one of the best track records of any fixed-income fund on a year-to-date, one-year and three-year time frame.
Eric Mogelof, managing director and head of U.S. global wealth management at PIMCO—which offers only actively managed fixed-income ETFs—says the large number of noneconomic bond buyers like central banks or insurance companies that aren’t necessarily looking to maximize returns creates inefficiencies, allowing active managers to generate excess returns.
Further, he says, supplies of a particular bond are determined by how much the borrower needs to borrow. A company or a country may need to borrow a lot of money, but it may not make sense for the buyer. “In a typical passive strategy, you’d own more of that bond, but from a credit perspective, that may not actually be the best choice,” Mogelof said.
Ryan Issakainen, senior vice president and ETF strategist at First Trust—which offers only actively managed fixed-income ETFs—concurs, especially when it comes to below investment grade. Credit indexes are flawed from an investment standpoint, he notes: “Why would you want to weight an index to the companies that are least likely to service and repay you? ... Managing that downside risk is extremely important.”
Steve Frazier, president of Frazier Investment Management, says he uses a mix of passive and actively managed fixed-income ETFs. According to him, the passive funds work best for clients with longer outlooks, while the active are more suited to clients with specific income-generation needs or specific volatility control or some other mandate.
For all these reasons, he says he believes actively managed fixed-income ETFs provide value over passive ones: “If I have a client who wants to generate 3-4% in income, we need to find that income somewhere. The general indexes typically aren’t going to provide that.”
Where Active Has An Edge
Morningstar’s Johnson said the high AUM and better performance of most actively managed fixed-income ETFs “tick all the right boxes.”
Active management needs to appeal to investors in that particular category, needs name recognition—a solid brand with a solid manager—and a great track record. It’s also much easier for a bond manager to get comfortable with an ETF’s daily transparency requirement than it is for a stock picker who might be managing a concentrated portfolio.
Lastly, it needs to have exposure to what’s in demand. This criterion may help explain why the short-duration fixed-income portfolios have the highest AUM in this space. Johnson says many of these funds are effectively money-market substitutes that came around in the wake of money-market reform and the general skittishness about interest rate risk given the current market environment.
Actively managed fixed-income ETFs may be garnering assets and be good for some more esoteric and illiquid markets, but that doesn’t mean passive ETFs can’t be used actively, says Matthew Bartolini, head of SPDR Americas research at State Street Global Advisors, which offers passive as well as actively managed fixed-income ETFs. There are ways to use passive fixed-income ETFs beyond simply using an ETF like AGG as a core product that doesn’t offer much yield.
With passive ETFs offering access to the global bond market, advisors can adjust for duration, currency risk, credit risk and other factors. “If you restructure these, even if you just equal-weight all the sectors, you’d get a better result than what AGG will give you,” he said.
Bartolini notes that when building portfolios, in addition to considering the return and risk assumptions, advisors need to think about their fee budget. Many of the actively managed fixed-income ETFs have higher expense ratios, with some topping over 100 basis points.
“If you’re willing to extend that fee budget and allocate to an active core manager who can essentially blend the interest rate and credit risk, while also managing the nuances of the macro uncertainty in this market environment, that’s something where an active fixed-income ETF can provide a [value],” he said.
Some actively managed ETFs are doing well because of the market cycle, Bartolini notes, like senior loans. Part of what’s worked in bond fund managers’ favor is that the market hasn’t seen a credit event since the global financial crisis 10 years ago, which has allowed them to pile on credit risk to boost performance, Johnson says.
That makes some advisors hesitant to use fixed-income ETFs—active or otherwise. Steven Wagner, co-founder of Omnia Family Wealth, says he’s concerned about underlying liquidity drying up if there’s a credit event, especially in more esoteric, lower-quality fixed-income ETFs.
Mauricio Gruener, co-founder and chief executive officer at GFG Capital—which uses actively managed fixed-income ETFs—says that with the changing fixed-income landscape with the Federal Reserve raising interest rates, “they make it a very attractive way to protect your investment.”
That could benefit an ETF like the Sit Rising Rate ETF (RISE), which is doing well after fees year-to-date and on a one-year basis, although it’s down slightly on a three-year basis.
Morningstar’s Johnson says the changing rate environment will make it more challenging for all bond ETFs, active or passive: “It’ll be more of a head wind for longer-duration bonds and less of a head wind for shorter-duration bonds.”