Close Close

Portfolio > Economy & Markets > Stocks

Bonds, Not Stocks, Are the Future for Active ETFs

Your article was successfully shared with the contacts you provided.

Fixed income ETFs are latecomers to the ETF universe, but they’re growing, providing liquidity and price discovery in the bond market and investment assets for active fund managers.

“A ton of actively managed mutual funds own HYG or LQD,” said Eric Balchunas, ETF analyst at Bloomberg Intelligence, referring to the high yield and investment grade bond index ETFs from iShares. He hosted one of several panels at this week’s Inside ETFs conference dedicated to the fixed income market.

The use of such indexes is one of the best ways for active managers to “outperform in the long haul,” according to Derek Pines, analyst and portfolio manager at Bramshill Investments.

Fixed income ETFs first launched in 2002, almost a decade after the first equity ETF, the SPDR S&P 500 (SPY) did. They currently account for just under $450 billion worth of assets in the ETF universe compared with about $2.5 trillion in equity assets even though the global bond market – with $100 trillion in assets – is about 30% larger than the global stock market. But they appear to be the best hope of the ETF market for actively managed funds.

Currently most fixed income ETFs are passive funds that track bond market indexes such as the iShares iBoxx High Yield Corporate bond index (HYG) or iShares iBoxx Investment Grade Corporate Bond index (LQD), but there are also smart beta fixed income funds like the Barclays Yield Enhanced U.S. Aggregate Bond Fund (AGGY) that overweight higher yielding bonds, and a growing number of actively managed ETFs, such as PIMCO Total Return Active Exchange-Traded Fund (BOND).

In the U.S. most passive bond ETFs are linked to the Barclays U.S. Aggregate Bond Index (AGG), which is heavily weighted toward Treasuries and excludes high yield and Treasury inflation-protected securities (TIPS), said Natalie Zahradnik, executive vice president of PIMCO, leaving actively managed ETFs “lots of room to grow.”

In addition, there is more interest in actively managed bonds ETFs than actively managed equity ETFs because of disclosure issues. ETFs usually requires disclosure of holdings daily.

“Equity fund managers don’t want others to know what they have in portfolios,” explained Michael Iachini, who leads the research effort on mutual fund and ETF lists for Charles Schwab Investment Advisory. They don’t want to show their hand fear of losing a competitive edge.

‘It’s not the same for bond markets,” said Iachini, explaining that bond fund managers traditionally buy and sell securities in an over-the-counter market, based on personal relationships, not on an open exchange, as stocks are traded.

In addition, there are thousands of bonds in the U.S. Aggregate index, which makes it impossible to replicate, and the index covers ohnly 17% of overall bond market – both reasons an actively managed bond ETF makes sense.

“Active management can provide better exposure to sector not represented in the aggregate,” said Zahradnik. “They can get better exposure to sectors not represented in the Aggregate” in an investment that’s “less volatile and can increase risk-adjusted returns.”

 — Related on ThinkAdvisor: