Advocating for active
SCOTT KEFER, CFA 20-Feb-2020
When investors hear “ETF,” they tend to think passive. That’s easy to understand given the spectacular growth of assets in passive strategies, particularly those in equity-focused ETFs. But before jumping to conclusions, let’s check the thesaurus. “Passive” and “ETFs” need not be synonyms. There’s an entire world out there of actively managed ETFs, and this active approach seems particularly well-suited to the expansive world of fixed income investing.
Actively managed fixed income ETFs provide investors with the potential advantages of the ETF wrapper—lower costs, liquidity, intra-day trading, transparency, tax efficiency—while also giving the manager some wiggle room to deviate from its bond benchmark. And in a world starved for yield where every basis point counts, actively managed fixed income ETFs may appear to have a better chance to boost yield, manage risk, and ultimately improve investor outcomes.
A case for an active fixed income strategy can be made from a deeper understanding of the best-known bond benchmark, the Bloomberg Barclays US Aggregate Bond Index (the “Agg”), which is widely used to track the U.S. investment-grade bond market. The earliest version of the Agg actually dates to two separate bond indexes in early 1970s, which were later combined and maintained by now-defunct Lehman Brothers. Today, the Agg has been rebranded by Bloomberg Barclays and includes Treasuries, government agency bonds, mortgage-backed bonds, corporate bonds, and some foreign bonds traded in the U.S.
Though the Agg offers an impressive cross-section of securities, it is somewhat hampered (some would say flawed) by its very structure since it is weighted based on the amount of issuance outstanding. In other words, weights within the index and the subsequent influence on performance are tilted to the largest debtor companies. That might not be such a good thing. History is replete with large bond issuers—often name-brand companies bloated with debt—defaulting. In the 1970s, utilities were often culprits. The dot.com bubble and the Global Financial Crisis engendered defaults among tech, housing and financial services companies. And energy companies have taken their turn in this notorious spotlight.
In its purest iteration, a passive fixed income strategy would be forced to hold dubious securities until they dropped out of the index. By then, the damage would be done. However, with a deeper fundamental analysis and better risk protocols, an active manager could (in theory) either avoid them or cut his or her losses. Along those same lines, the Agg is permitted to hold only investment-grade securities, so if those issues are downgraded to junk status the Agg must sell those positions by rule. In contrast, an active management team can evaluate the credit quality of any downgraded bond relative to its price and make an educated investment decision, rather than being a forced seller.
Another criticism and possible limitation of any passive fixed income strategy that closely tracks the Agg revolves around agency mortgage backed securities (MBS), which recently constituted approximately 27% of the index. Without going too deep, the sensitivity of MBS to fluctuations in interest rates is often less favorable when compared to other fixed income securities of similar maturities. The reason has to do with how MBS are impacted by homeowner trends in refinancing their mortgages. So while the Agg has more than a quarter of its portfolio in MBS, active fixed income managers can eschew them as they see fit.
Gaining an edge
The very structure of the bond market is also more conducive to active management. The domestic bond market is much larger than the stock market, with $40-plus trillion in a vast array of fixed income securities. It’s huge and diverse, yet the over-the counter-nature of bond trading and pricing is far less transparent than equities where securities are listed on public exchanges.
An opaque market with more complex securities (with varying structures and call features) suggests that it’s easier to have mispricing in fixed income securities than in individual stocks. Thus, while it may be tough to get an advantage in equities (especially in large-caps), it may be easier for some bond investors to gain an information advantage through diligent credit research and better trading. In fact, size and scale truly matters for bond managers, not just in terms of trade execution, but also because it may provide greater access to the new issue market. All these factors have made it potentially more likely for active fixed income managers to outperform their benchmarks compared to their equity counterparts.
I believe that the fixed income universe is tailor made for active management, and combining it with the inherent structural advantages of ETFs is a sound approach. So while active management has become a punching bag for financial journalists, perhaps it’s time to punch back, especially if you are active fixed income manager.