Fixing fixed income: How active ETFs can improve traditional passive approaches
Passive bond ETFs aim to provide representative market exposure, but inadequate market data means they may not deliver what they promise. Active ETFs could be a more effective solution.
4 minute read
Key takeaways:
- Passive bond ETFs have improved accessibility but not precision, as bond markets lack meaningful data for selecting and weighting securities.
- Large asset managers with advanced systems are best-equipped to understand bond market liquidity and dynamics.
- Active ETFs could be the best approach for accurate market exposure, even for core allocations.
Bond ETFs – what is the point?
The core purpose of exchange-traded funds (ETFs) is to allow any investor – whether an individual or a large institution – to implement their chosen asset allocation quickly and efficiently. In the complex world of fixed income, the arrival of bond ETFs has been welcomed, particularly by non-specialist investors like multi-asset funds and smaller institutions.
In many respects they’re a success, delivering low-cost exposure and gathering significant assets under management. However, when it comes to the most critical aspect – providing accurate and representative market exposure – passive bond ETFs often miss the mark. Investors aren’t getting the kind of exposure they think they’re getting, and the issue boils down to data.
Building a bond index is easier said than done
Creating an investable index involves two key decisions: how to select securities and how to weight them. The goal is to create a portfolio that is both representative and liquid. In equity markets, this is relatively straightforward. Trading volume data is readily available as a measure of liquidity while market capitalisation – though imperfect – provides an adequate gauge of a company’s importance in the market.
In fixed income, indexation is much more difficult. Broad benchmarks typically comprise not hundreds but thousands of securities, making efficient replication a challenge. For example, Bloomberg’s Euro Corporate Bond Index includes over 3,500 bonds. However, the real problem is how those bonds are selected and weighted. Most indices rely heavily on issue size and/or the amount outstanding because this is the data that’s readily available. Even “liquid” indices, designed to be easier to replicate, use these metrics to select the largest bond issues. But unfortunately, availability isn’t the same thing as relevance.
Using issuance size as a proxy for liquidity is deeply flawed. In reality, large institutional investors often buy bonds in the primary market and hold them to maturity. As a result, true liquidity is fragmented and can’t easily be captured by index rules. Similarly, weighting securities by the amount of outstanding debt has long been criticised. It rewards more heavily-indebted issuers, which can distort exposure. More generally, it is being used as a stand-in for market data that simply isn’t available. This makes passive replication in fixed income inherently imprecise.
The active ETF advantage
Specialist fixed income managers are aware of these limitations. Much of the imperative for active management in fixed income isn’t outperformance but accuracy. Outperformance is a nice-to-have, but the primary challenge is to accurately reflect a market that isn’t well-defined by standard data points and where liquidity is hard to measure. Solving this problem requires extensive resources, technology and systems to generate deep market insights and the resources and technology to properly analyse and understand complex markets. Solving this problem requires sophisticated systems and visibility across and within bond markets – resources typically found in large asset managers with a significant market presence.
Collateralised Loan Obligations (CLOs): Passive limitations
Loans and CLOs now represent a growing share of global debt markets, meaning it’s increasingly important to include them in diversified portfolios. CLO indices are now available but passive ETFs haven’t sprung up to meet investor demand. In fact, all CLO ETFs are actively managed. The data, systems and due diligence needed to properly understand and compare CLOs are beyond the scope of what index and market data providers can offer. What’s more, a passive approach would tend to reflect dealer inventory (bonds that a bond dealer holds in their own account for trading purposes), with no consideration of manager concentration and other portfolio risk factors.
Raising the bar for core fixed income
The challenges of indexation don’t just affect the more esoteric corners of the bond market. Even the most basic building blocks of a fixed income portfolio could benefit from an active approach based on deep market insights.
If the goal is to reflect a market that doesn’t conform well to traditional indexing, active ETFs can provide a more accurate and effective solution.
Active investing: An investment management approach where a fund manager actively aims to outperform or beat a specific index or benchmark through research, analysis and the investment choices they make. The opposite of Passive Investing.
The Bloomberg Euro Corporate Bond Index contains fixed-rate, investment-grade Euro-denominated bonds from industrial, utility and financial issuers only.
Bond: A debt security issued by a company or a government, used as a way of raising money. The investor buying the bond is effectively lending money to the issuer of the bond. Bonds offer a return to investors in the form of fixed periodic payments (a ‘coupon’), and the eventual return at maturity of the original amount invested – the par value. Because of their fixed periodic interest payments, they are also often called fixed income instruments.
Bond dealers: Buy and sell bonds executing trades on behalf of clients or their firm, playing a crucial role in bond markets by helping to facilitate liquidity, investment opportunities, and determine bond prices, among others.Concentrated portfolio: A portfolio concentrated in a small number of holdings or with high weightings to its largest holdings. These portfolios typically carry greater risk than more diversified portfolios, given that an adverse event could result in significant volatility or losses, but the potential to outperform is also greater.
Collateralised Loan Obligation (CLO): A bundle of generally lower quality leveraged loans to companies that are grouped together into a single security, which generates income (debt payments) from the underlying loans. The regulated nature of the bonds that CLOs hold means that in the event of default, the investor is near the front of the queue to claim on a borrower’s assets.
Diversification: A way of spreading risk by mixing different types of assets/asset classes in a portfolio, on the assumption that these assets will behave differently in any given scenario. Assets with low correlation should provide the most diversification.
Exchange traded fund (ETF): A security that tracks an index, sector, commodity or pool of assets (such as an index fund). ETFs trade like an equity on a stock exchange and experience price changes as the underlying assets move up and down in price. ETFs typically have higher daily liquidity and lower fees than actively managed funds.
Exposure: The amount an investor has invested in an asset/market and could potentially lose should an investment fail. It is another way of describing financial risk.
Index: A statistical measure of group of basket of securities, or other financial instruments. For example, the S&P 500 Index indicates the performance of the largest 500 US companies’ stocks. Each index has its own calculation method, usually expressed as a change from a base value.
Liquidity/Liquid assets: Liquidity is a measure of how easily an asset can be bought or sold in the market. Assets that can be easily traded in the market in high volumes (without causing a major price move) are referred to as ‘liquid’.
Overweight: Having a relatively large exposure to an individual security, asset class, sector, or geographical region than a relevant benchmark, such as an index.
Passive investing: An investment approach that involves tracking a particular market or index. It is called passive because it seeks to mirror an index, either fully or partially replicating it, rather than actively picking or choosing stocks to hold. The primary benefit of passive investing is exposure to a particular market with generally lower fees than you might find on an actively managed fund. The opposite of active investing.
Underweight: To hold a lower weighting of an individual security, asset class, sector, or geographical region than a portfolio’s benchmark.
These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.
Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
The information in this article does not qualify as an investment recommendation.
There is no guarantee that past trends will continue, or forecasts will be realised.
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4 minute read
Key takeaways:
- Passive bond ETFs have improved accessibility but not precision, as bond markets lack meaningful data for selecting and weighting securities.
- Large asset managers with advanced systems are best-equipped to understand bond market liquidity and dynamics.
- Active ETFs could be the best approach for accurate market exposure, even for core allocations.
