Adding value with active fixed-income ETFs
As volatility has returned to markets, active ETFs have gained traction with investors. Learn more about why we believe actively managed fixed-income ETFs can benefit investor portfolios.
Active ETFs have slowly gained traction with investors since they first appeared in the marketplace in 2008, 15 years after the launch of the first ETF. Recently, there have been signs that investors are becoming more interested in gaining exposure to active management while simultaneously receiving the benefits of the ETF structure.
Though geopolitical risk, aggressive central bank policy, and economic uncertainty stressed equity and fixed-income markets over the course of 2022, ETFs have continued to see net inflows. In total, ETFs gathered $597.9 billion during 2022, their second-highest year ever.
Notably, while active ETFs commanded only 5.3% of market share at year end, 14.4% of net inflows went to actively managed ETFs, suggesting that these strategies are of particular interest to investors. Issuers are also showing interest in this space, with active ETFs accounting for 63.0% of all launches last year, marking the third year in a row that active launches have outpaced their passive peers.
The changing bond market
The first active ETF, launched in 2008, revolutionized fixed-income investing by offering investors broad exposure to the bond market in a liquid and transparent way. Since then, the number of active fixed-income ETFs has grown exponentially. Currently, over 40% of the fixed-income ETFs available to investors are classified as active ETFs.1
In our opinion, one factor behind this rapid growth in active fixed-income ETFs is the changing composition of the U.S. bond market over the past decade. Passive, index-linked core approaches have become much more concentrated in government debt, which tends to have lower yields relative to other areas of the bond market.
U.S. Treasuries, MBS, and corporate bonds are the largest components of today’s bond market
U.S. bond market size by sector
Source: SIFMA, 12/31/21. https://www.sifma.org/resources/research/fixed-income-chart/. Money market securities are excluded from the chart and calculation.
Due to accommodative U.S. Federal Reserve policy and quantitative easing that occurred in reaction to the financial crisis, the size of the U.S. Treasury market has ballooned. At the end of December 2022, Treasuries accounted for over 40% of the Bloomberg U.S. Aggregate Bond Index. Over that same time period, the duration of the Bloomberg U.S. Aggregate Bond Index has steadily risen and is now at more than six years.2 This means that passive core fixed-income ETFs carry a fair amount of interest-rate risk at a time when yields are rising.
Since active fixed-income ETFs aren’t required to track the benchmark, these ETFs can instead shift duration based on the portfolio management team’s outlook for interest rates. Sector allocation can also be managed based on the team’s ability to find relative value opportunities within the investment scope of the ETF. The range of returns between fixed-income sectors can often be significant, creating an opportunity for active managers to add significant value over time.
Reaching for yield can be tricky
Active management can also benefit income-sensitive investors who are looking beyond core fixed-income exposure. As the market shifts away from the low-yield regime that has characterized much of recent history, investors may be tempted to take advantage of the attractive income opportunities that are now available to them across a variety of asset classes, including floating-rate loans, securitized assets, high-yield bonds, and non-U.S. bonds; however, investors should be aware that there is often a trade-off between yield and downside risk.
The trade-off between yield and risk
Current yield vs. 5-year maximum drawdown
Source: Morningstar Direct, as of 12/31/22. For illustrative purposes only. Categories in chart are represented by the following indexes: Intermediate Treasury (ICE U.S. Treasury 7–10 Year Bond Index); national muni bonds (S&P National AMT-Free Municipal Bond Index); Bloomberg U.S. Aggregate Bond (Bloomberg U.S. Aggregate Bond Index); investment-grade corp (Markit iBoxx USD Liquid Investment Grade Index); high-yield corp (Markit iBoxx USD Liquid High Yield Index); U.S. real estate investment trusts (REITs) (Dow Jones U.S. Real Estate Index). Diversification or asset allocation does not guarantee a profit or protect against loss in any market. It is not possible to invest directly in an index. See definitions in the disclosures section below.
Since fixed income often acts as the ballast within a portfolio, this underscores the importance of limiting the potential for drawdowns within these types of investments. With capital preservation as a top priority, risk management becomes even more important.
Investors who opt for actively managed fixed-income ETFs can benefit from portfolio management teams that consider yield in conjunction with duration, credit quality, and sector allocation. Combined with fundamental research to support selection of specific issues, portfolio managers can be nimble and adjust the portfolio to the prevailing market environment.
Looking ahead, we believe that this shift toward active ETFs will continue, particularly within fixed income, where experienced portfolio management teams can help to manage risk while potentially adding value over time.
1 ETF.com, as of 2/3/23. 2 Bloomberg, as of 12/31/22.
Important disclosures
The views presented are those of the author(s) and are subject to change. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. Past performance does not guarantee future results.
The ICE U.S. Treasury 7–10 Year Bond Index seeks to measure the performance of outstanding U.S. Treasury bills with a minimum term to maturity greater than 7 years and less than or equal to 10 years. The S&P National AMT-Free Municipal Bond Index tracks the performance of the investment-grade tax-exempt U.S. municipal bond market, excluding the U.S. territories. The Bloomberg U.S. Aggregate Bond Index tracks the performance of U.S. investment-grade bonds in government, asset-backed, and corporate debt markets. The Markit iBoxx USD Liquid Investment Grade Index tracks the performance of U.S. dollar (USD) denominated investment-grade corporate debt. The Markit iBoxx USD Liquid High Yield Index comprises USD high-yield bonds selected to represent a balance of the USD high-yield corporate bond universe. The Dow Jones U.S. Real Estate Index tracks the performance of real estate investment trusts (REITs) and other companies that invest directly or indirectly in real estate. It is not possible to invest directly in an index.
Drawdown is a measure of market declines from a peak to a subsequent trough.
Fixed-income investments are subject to interest-rate and credit risk; their value will normally decline as interest rates rise or if a creditor, grantor, or counterparty is unable or unwilling to make principal, interest, or settlement payments. An issuer of securities held by the fund may default, have its credit rating downgraded, or otherwise perform poorly, which may affect fund performance. Investments in higher-yielding, lower-rated securities are subject to a higher risk of default.
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