This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Jack Gilligan, director of research for ClearRock Capital.
We spent two days this month in Newport Beach, California, at the Inside Fixed Income conference. It was a great opportunity to try to get our finger on the pulse of the active versus passive debate in fixed income, a deeper dive into the intricacies of trading fixed-income ETFs and an attempt to soak up the market outlook of industry sages such as Dennis Gartman, Bob Smith and Jim Grant.
Here are our key takeaways from two jam-packed days:
Active Fixed-Income ETFs Here To Stay
When the big asset managers see an opportunity to increase assets under management time and again, we have seen them charge full steam ahead into any given segment of the market.
Today fixed-income ETF assets are dominated by passive investment vehicles. However, active ETFs are growing faster. In the opaque landscape of bond strategies with a lack of industry consensus around proper benchmarks beyond the narrow Barclays Aggregate Bond Index, this asset class seems ripe for active bond managers to gain market share using the ETF structure.
We think this trend is just starting, and will continue aggressively into 2018. The key question is, can active bond managers earn their fees if the ground beneath their feet starts to move with a new Fed chair and the prospect of increased interest rate volatility with the unwinding of QE2?
Cheap Access To Opaque Bond Sectors
There has long been a debate about liquidity mismatches between bond ETFs and their underlying basket of bonds. It has become clear to us that on a day-to-day basis, the ability to cheaply and quickly access bond risk exposures has been a huge benefit to investors.
The spread benefits of ETFs versus their underlying bonds are staggering. The big risk investors see in bond ETFs is how to price the ETF if the underlying basket is difficult to price in times of stress. Those risks are real, whether you own the actual bonds or the ETF.
Inflation Always A Touchy Subject
Everyone feels obliged to have an inflation outlook of some sort. Our takeaway is that the inflation uptick over the past few months has helped with some steepening of the curve and the recent climb in the 10-year Treasury.
However, the still-floundering wage inflation data, and the massive amounts of money supply outweighing demand, should keep inflation from moving too far above the Fed’s 2.0% target.
Outlook For Rates & Central Banks Is Key
We felt there was broad consensus that U.S. interest rates are heading higher in the next six to 12 months. However, big dislocations to the upside are unlikely given the downward pressure on rates from demographics, foreign buyers and slack in inflation.
Furthermore, most credit spreads are at or near multiyear lows and the risk/return profile for those sectors are modest from these levels. However, fundamentals are strong and possibly strengthening into 2018. Valuation is not necessarily a sell signal.
The one area that was consistently mentioned as more attractive was emerging market debt in both U.S. dollars and local currency, such as the iShares JP Morgan USD Emerging Markets Bond ETF (EMB). This ETF effectively hedges the risk from foreign currency while at the same time retaining EM exposure—an attractive investment, in our opinion.
It’s always great to spend a few days with our ETF peers, and we look forward to doing it again soon.
At the time of writing, ClearRock clients currently owned AGG and EMB. Jack Gilligan is director of research for ClearRock, an SEC-registered investment advisor with offices in San Francisco and Sun Valley, Idaho. Contact: [email protected]. For a full list of disclosures, please click here.