Actively managed fixed-income ETFs are surging in popularity compared with their passive peers. The number of these ETFs and their assets under management (AUM) have risen significantly because these ETFs tend to outperform their benchmarks more often, states a recent report from Toronto-based National Bank Financial Inc. (NBF).
Although these ETFs have higher management fees than index-tracking fixed-income ETFs, the portfolio managers who manage the active mandates can make market calls on interest rates and credit risk, as well as take advantage of the fact bond trading is less efficient and transparent than that in public equities markets, according to the report, which was co-authored by analysts Daniel Straus and Ling Zhang, and ETF industry executives.
Given the recent boom in launches of actively managed fixed-income ETFs, Straus and Zhang calculated that these products now account for 42% of the total number of fixed-income ETFs and 24% of the total AUM held in fixed-income ETFs. (The NBF tally includes all bond categories, along with senior loans, but excludes preferred shares.)
“Although the sentiment for active management has taken a beating in this era of cost compression and rising index assets, the attention toward actively managed fixed-income funds is not without grounds,” the NBF report states.
Straus and Zhang looked at the relative performance of actively managed fixed-income ETFs over periods of one, two, three, four and five years, ended July 31, and found that “during each annual lookback period between one and five years, a greater number of active funds outperform our assigned benchmarks than underperform.”
One reason for this outperformance is that actively managed fixed-income ETFs can deviate from their benchmark’s average duration and credit quality, says Michael Cooke, senior vice president, ETFs, with Toronto-based Mackenzie Financial Corp.
“Perhaps at this point of the market cycle, it makes a lot of sense to have active management to provide opportunities for yield enhancement, mitigate some of the interest-rate risk that we now see rearing its head in the financial markets [and] avoid the pitfalls of poor credit,” he says.
At the individual security level, actively managed ETFs are free to deviate from market-cap weightings. That differentiates the ETFs from their conventional, index-hugging peers, for which the largest bond holdings are those with the largest debt outstanding.
“All you’re determining is that these are companies that can take on debt, but [that] doesn’t necessarily mean it’s the best debt,” says Mark Noble, senior vice president, sales strategy, with Toronto-based Horizons ETFs Management (Canada) Inc., which has an extensive fixed-income lineup that consists mostly of active mandates. “As a result, what you begin to see is inefficiencies in indices because they weight bonds based on just outstanding debt.”
The larger bond issues that dominate passive fixed-income ETFs also tend to be more actively traded, which translates into narrow bid/offer spreads, Cooke notes. As a result, there’s no “liquidity risk premium” to be earned by active management.
Active mandates provide a wider range of opportunities in broader categories, such as Canadian fixed-income and global fixed-income, in which there’s freedom to vary duration and hold both government and corporate credits.
A key point of differentiation of actively managed ETFs within their peer groups is the extent to which the former employ active strategies. For example, Invesco Tactical Bond ETF, which falls in the Canadian fixed-income category, combines elements of both active and passive investing.
“This is a tactically managed fund of passive or strategic beta ETFs,” says Christopher Doll, vice president, ETF sales and strategy, at Toronto-based Invesco Canada Ltd. Invesco Tactical Bond ETF is exposed primarily to Canadian long-term government bonds and one- to five-year Canadian corporate bonds through its underlying ETF holdings – although the split between these two main components can vary widely.
Beyond that, says Doll, the team that manages the ETF at Atlanta-based Invesco Advisers Inc. can hold smaller portions in high-yield bonds, foreign government bonds and real-return bonds.
Meanwhile, Mackenzie Core Plus Canadian Fixed Income, managed by Toronto-based Mackenzie Investment’s fixed-income team headed by Steve Locke, senior vice president, investment management, is a fully active strategy that invests selectively in fixed-income securities, mostly investment-grade Canadian issues. However, the ETF also can hold up to 30% of its portfolio in foreign securities and up to 25% of its portfolio can consist of issues that are below investment-grade.
These opportunities for yield enhancement, says Cooke, can only be achieved through effective active management. So far, so good for this Mackenzie ETF. Since its inception in mid-April 2016, net annualized return is 2.45% – 100 basis points (bps) ahead of the benchmark FTSE TMX Canadian universe bond index.
The greatest scope for active management is in the global fixed-income category, as exemplified by Horizons Global Fixed Income ETF, managed by Montreal-based Fiera Capital Corp. This ETF’s broadly diverse holdings partly consist of other ETFs, most of which are actively managed Horizons ETFs. These ETFs are combined with direct holdings in various fixed-income securities, which can include high-yield and emerging-markets bonds, and preferred shares.
The advantages that actively managed fixed-income ETFs enjoy don’t include cost. Management fees are less than 10 bps for some Canadian passive strategies, enabling index ETFs such as those from BMO Asset Management Inc. and BlackRock Canada Asset Management Ltd.’s iShares division to generate above-average risk-adjusted performance.
In contrast, management fees of actively managed fixed-income ETFs generally are 50 bps or more – with no guarantees of superior performance.