Exchange traded funds (ETFs) are widely credited with breathing new life into active management and nowhere is that more apparent than in the fixed income arena.
A variety of reasons explain why that’s the case, not the least of which is the fact that many active managers continue lagging their benchmarks with both domestic and international stocks, but advisors’ embrace of active bond ETFs goes beyond that point.
While many of the oldest and largest passive bond ETFs are cost-effective and easy to understand, active counterparts offer advisors and clients flexibility not germane to passive equivalents. Said another way, active managers can be more responsive to credit and duration opportunities than a passive bond fund can be.
That’s a story worth telling at a time when inflationary pressures have been reignited and as the possibility of interest rate cuts this year remains up in the air. So while active bond ETFs are long-term instruments, some are worth considering over the near-term.
Active Ameliorates Passive Drawbacks
As noted above, many old guard (and plenty of newer ones, too) passive bond ETFs are cheap to own and have expansive lineups of bonds from a variety of fixed income segments. However, many of these funds are also cap-weighted, meaning they tilt toward the most indebted issuers. In some passive strategies, that introduces credit quality concerns. Active bond ETFs can mitigate those worries.
“Unlike active portfolios, market indices don’t consider an issuer’s default risk or declining credit rating. This risk tends to be more prevalent in slowing economies, when credit risk typically rises,” notes American Century. “Passive strategies with investment-grade mandates may have to sell securities with declining credit ratings as their prices are falling.”
There’s also the issue of index replication. For those that aren’t indexing nerds, this is an interesting in the fixed income world because not all of the bonds in a tracked index may be available to all investors. As such, an ETF provider of a passive product engages in (in some circumstances) index replication. It’s not the end of the world, but it is an issue active bond managers avoid.
“Investors cannot invest directly in a market index, so fund managers must do their best to replicate the index’s composition,” adds American Century. “However, it’s unlikely that all the bonds represented in a broad market index will be available for purchase. So, index managers typically engage in sampling or optimizing in their attempts to mimic a broad fixed-income index.”
Active Fixed Income’s Value Proposition
Advisors, clients and fixed income investors can benefit from active managers’ ability to manage credit and interest rate risks while capitalizing on related opportunities. But there’s also the issue of value. Like stocks, some bonds offer more value than others and it’s difficult for passive index funds to exploit those favorable scenarios.
“Active managers seek to uncover value across the fixed-income spectrum, including the new-issues market,” according to American Century. “They can invest in places that popular market indices often ignore, such as smaller and underfollowed sectors, securities, issuers and countries. Additionally, active managers are free to exit securities they believe have reached their valuation potential, while passive indices must continue holding them if they’re a benchmark component.”
American Century offers an extensive lineup of active bond ETFs, including the Multisector Floating Income ETF (FUSI) and the Multisector Income ETF (MUSI), among others.
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