Fund selectors are calling for more active fixed income ETFs as they look for a low-cost solution to tackle inefficiencies in the bond market.
In a world where fixed income is playing a greater role in portfolios, products have entered Europe at a trickle in recent years, with just 33 active fixed income ETFs on the continent versus 87 in equities, according to data from Morningstar.
However, investors are ready for the floodgates to open with demand growing for “high conviction” active bond ETFs as they look to gain an edge by playing the idiosyncrasies of fixed income, while addressing some of the challenges passive bond ETFs have in fully replicating indices.
Highlighting the opportunity for the wrapper, the latest SPIVA Europe from S&P Dow Jones Indices (SPDJI) made better reading for fixed income versus equities, where active managers consistently underperform.
For example, just 24% of active managers underperformed in the sterling-denominated corporate bond fund space over the past year, rising to 47% in the sterling government bond space.
Francis Chua, fund manager at Legal and General Investment Management (LGIM), said he currently does not hold any active fixed income ETFs in his portfolio but would not rule out allocating to the more nuanced areas of the market via ETFs in the future.
“At some point down the line we will look at them,” he continued. “Areas such as global high yield and emerging market debt we tend to look at active managers, so it will be interesting to see if we get a version of this in the active ETF space.”
Fixed income nuances
Active managers have so far had the edge in the fixed income space where passive strategies fail to take advantage of the ever-evolving bond market.
Trading underlying bonds can be difficult, with liquidity profiles of US Treasuries being materially different from investment-grade corporate issues, making buying and selling of the underlying holding expensive.
This means ETFs often take an optimised approach, selecting the most liquid bonds instead of replicating the full index.
While passive bond ETFs serve investors well as a default, Dan Caps, investment manager at Evelyn Partners, said challenges around liquidity and duration profile could be better remedied by active ETFs.
“The fact the $12bn iShares Core Global Aggregate Bond UCITS ETF (AGGG) only holds around half of the issues within the underlying Bloomberg Global Aggregate index tells you there are significant difficulties in trading some bonds,” he said.
“The indices themselves can present some notable challenges to allocators, and this creates opportunities for active and systematic strategies to help better meet investors’ needs.”
Chua added an ETF that could capitalise on new issuance premiums would also be attractive. “Active managers have shown to be consistent outperformers in picking up new paper at a discount,” he said. “Index providers would typically do this monthly or quarterly depending on when they rebalance, but if they had a bit more dynamism in their approach they could pick up some of that discount.”
In a developing interest rate and inflationary environment, active managers have had the ability to exploit mispricing from “irregular curve shapes”, according to Enrico Girotti, portfolio manager at Banca Patrimoni.
“Creating active ETFs means trying to reduce costs while catching carry strategies and providing some kind of alternative to US Treasury bond issues or overnight rates returns,” he said.
Alberto García Fuentes, head of asset allocation at ACCI Capital Investments, agreed, adding active fixed income ETFs provide the flexibility to take advantage of changing interest rates, but said it was important to select the right strategy.
“Active fixed income ETFs are valuable because they offer the flexibility to take advantage of changes in interest rates, credit spreads and changing economic conditions,” he said. “In a more inefficient market, credit analysis and security selection can be important sources of alpha. Selecting more liquid securities and minimising bid-ask spreads are also important.”
‘High-conviction’ opportunity
With limited options currently in the market, the challenge is for issuers to build genuine low-cost active fixed income ETFs that can take advantage of these inefficiencies.
According to a recent Morningstar report, two-thirds of active ETFs are invested in short-term strategies where the bonds are most liquid, while a multi-factor, systemic approach offered by the likes of JP Morgan Asset Management and Fidelity International also account for the majority of the product offering.
“Like in equities, high-conviction active ETFs are difficult to find. In many cases, the ETF format hosts a lower-alpha, lower-conviction version of an existing strategy from the same fund company,” the report said.
For example, the $50m AXA IM US High Yield Opportunities UCITS ETF (AHYT) – which leverages the same research as the AXA WF US High Yield Bond fund – has around 300 issuers compared to 200 in the original fund.
“Given the liquidity challenges inherent in the high-yield space, a more diversified approach is probably inevitable when choosing the ETF format, but that also implies active ETF investors should probably moderate their excess return expectations,” Morningstar said.
Chua said the “cost dynamic” around trading active fixed income ETFs “remains unclear”, but that it was important to understand if the ETF offered a more “cost-effective solution” before investing.
The ability to take on traditional sources of excess return in the fixed income space will be a challenge for ETF issuers. These include higher duration, increased credit risk and positions in less liquid securities that can widen bid-ask spreads.
There are signs investors' fortunes could be turning. Speaking at ETF Stream’s recent ETF Ecosystem Unwrapped 2024 event, Vanguard said it was considering launching active fixed income ETFs while Janus Henderson’s recent acquisition of Tabula Investment Management has been viewed as a “huge opportunity” to disrupt the active fixed income space in Europe.
Despite this, Girotti believes the lack of demand stems from the “success of standard ETFs usage in terms of cost efficiency” and active manager woes in fixed income.
“Given the troubled times that are facing active funds, these kind of products may be offered as an alternative,” he said.
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To read the full edition, click here.
