Tips for Choosing an Actively Managed Bond ETF

Journal of Financial Planning: June 2015


When financial planners choose bond ETFs, it is typically for their income, diversification, and liquidity characteristics—important features for helping clients achieve their investment objectives. We propose that planners also look for active management in bond ETFs.

Actively managed ETFs were introduced in 2008. To date, the majority of actively managed ETFs have had a fixed-income focus. The vast fixed-income universe, with its diversity and complexity of securities in terms of types, number, quality, maturity, liquidity, etc., lends itself well to an active, fixed-income ETF vehicle. From an investor’s perspective, such ETFs offer a way to combine the potential advantages of active management in the fixed-income universe with the trading flexibility of exchange-traded products. Active fixed-income ETFs provide ETF investors with the opportunity to benefit from the research, trading, and resources supporting active strategies.

Not All Benchmarks Are Created Equal

In the stock market, benchmarks typically reflect the combined market value of the holdings. Therefore, the S&P 500 Index is based on the market value of the 500 stocks in the index. If the value of an index stock rises, its value then represents a larger fraction of the index. Therefore, the most valuable companies end up having the largest weightings in the index.

Fixed-income indices are fundamentally different. They are not based on market value, but on the size of debt issuance. The more index-eligible debt a company issues, the larger weighting it has in the index. Its weight increases, not because it is more valuable or its credit worthiness has improved, but simply because it has issued more debt. A passive bond ETF by rule would be increasing its exposure to exactly the credits it should be avoiding, while an active manager, with the benefit of a strong research team, can look to avoid those issuers.

Another important aspect of fixed-income benchmarks is how many bonds can be left out due to the inclusion criteria of an index. These criteria are firmly (and appropriately) adhered to by the benchmark index, and also by the passive portfolios that attempt to mirror it.

The U.S. Barclays Aggregate Index has a well-defined set of inclusion rules and strives to be representative of the overall investment-grade fixed-income market. However, even though this index contains more than 8,000 securities, it represents just a subset of the broader bond market. SIFMA estimates that the U.S. bond market had an aggregate market cap of $35 trillion as of June 30, 2014. In contrast, the comparable value for the Barclays U.S. Aggregate Bond Index was $15 trillion.

Maintaining clear criteria supports the transparency and usefulness of the index, contributing to its popularity as a benchmark. However, the wider opportunity set for active managers may allow active bond ETFs to either find more attractive investment opportunities or increase the diversification of the ETF.

Looking Beyond Expense Ratios and Previous Returns

Choosing the right active bond ETF for your clients involves some research. Past performance is no guarantee of future results, so planners should look at additional aspects aside from the expense ratios and previous returns.

Some key considerations in choosing an active bond ETF include:

The research and trading resources of the manager. Is the manager well-resourced to analyze the credit risk of various bonds, find and take advantage of market inefficiencies, and achieve lower trading costs through expert trading?

The benchmark of the strategy. Does the return and risk profile of the benchmark—and of the active strategy measured against it—align with the investor’s objectives? For example, if the primary objective for investing in a bond ETF is to diversify a portfolio that is heavy in equities, an investor might prefer a strategy that has shown lower correlations to equity returns.

The overall level of risk within the strategy. How much risk is an active bond ETF manager taking relative to the portfolio’s return? Is the risk similar to that of the benchmark index? If not, is risk consistent with investors’ expectations about the ETF? If an active manager is earning higher returns than the benchmark by investing in much riskier bonds or sectors, it may be appropriate to consider whether the additional returns are worth the extra risk.

The sources of risk within the strategy. Sources of risk in a bond ETF include credit risk—the possibility that bonds will default or lose value due to credit deterioration—and duration, sensitivity to interest-rate changes. A benchmark index, and the passive approaches tied to it, will have certain credit risk and duration characteristics that are determined purely by the set of available bonds that fit within the index guidelines. For an active bond ETF, the level of credit risk and a duration target can be intentionally determined by the manager. Therefore, investors may want to understand how and why an active ETF’s sources of risk differ from those of the benchmark index.

Other elements of the ETF mandate, including any guidelines or restrictions. How much flexibility does the manager have in choosing the sector exposure, credit-quality exposure, and interest-rate sensitivity of the holdings? An investor primarily seeking diversification may benefit from different guidelines than an investor mainly seeking income.

The structural risk controls. How are investment decisions made and monitored at the firm managing the ETF? What incentives are put in place to maintain appropriate risk levels?

Many financial planners seek exposure to bond ETFs for three key characteristics: income, portfolio diversification, and liquidity. How they achieve this exposure should be consistent with their overall objectives. Active bond ETFs offer investors the potential for returns exceeding those of an index by taking advantage of a wider opportunity set of possible investments and the flexibility to make qualitative judgments. Various active management strategies can augment total returns for active bond ETFs, even in a rising-rate environment.

Pramod Atluri, CFA, and Ford O’Neil are portfolio managers with Fidelity Investments.

Exchange-traded funds (ETFs) are subject to market volatility and the risks of their underlying securities. The opinions provided are those of the authors and not necessarily those of Fidelity Investments. Information provided is general in nature. It is not intended to be, and should not be construed as, legal or tax advice. For investment professional and institutional investor use only.


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