The beauty of active management is that a portfolio doesn’t have to look like an index. Managers can freely make investing decisions based on a variety of factors and aren’t forced to stick with a broad passive mandate. The hope is this active management can derive additional alpha and boost returns. When it comes to equities, the data is mixed on whether that assumption is true. However, when it comes to bonds and fixed income, active management can work wonders.
And investors are embracing that fact.
Thanks to the current interest rate and global macroenvironment, flows into active fixed income ETFs have been swift. Investors continue to gobble up new and previously launched funds at a fevered pace. With that, fixed income ETFs could be the best place for asset managers to find growth and exploit the best of what active management has to offer.
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Fund Flows and Active Management
It’s no secret that passive and index investing has been eating active management’s lunch for what seems like a decade now. Most of this has been happening on the equity side of the equation. Thanks to higher costs/fees, ‘closet indexing’, and other factors, many active funds have consistently underperformed their benchmarks and passive peers. According to the latest Morningstar report on fund returns, of the nearly 3,000 active funds, only 25% of all funds beat their passive rivals over a 10-year period. Breaking down that data further, the numbers are even grimmer for certain segments of the market. Large-cap U.S.-focused active funds—the largest segment of an investor’s portfolio only saw 11% of the funds beating passive benchmarks.
ETFs have started to shift these numbers in favor of active managers. However, the underperformance figures are striking.
The one bright spot in Morningstar’s data: active fixed income funds. Nearly 85% of active funds in the intermediate core bond sector managed to outperform benchmarks over the last year. Longer term, 66% of the cheapest active funds managed to outperform over the last decade.
The key to that outperformance is how fixed income indexes are constructed. Market-cap fixed income indexes like the popular Bloomberg Barclays Aggregate Bond Index are weighted based on the amount of debt outstanding. That is, the firms with the most debt get a higher place in the index. Essentially, you’re rewarding the biggest debtors with more pull on the index. That’s a problem for a number of factors.
Because active fixed income managers can do credit analysis, dig into bonds, find those trading at discounts to par, hedge interest rate risk, etc., they have a real opportunity to outperform. This seems to be the case when it comes to historical returns. So, while active equity managers struggle to beat the S&P 500, their fixed income peers are winning.
Investors Take Notice
And it looks like investors are taking notice. According to Bloomberg, fund flows are showing the active market is starting to look a bit split. Looking at fund flows, active funds lost about $50 billion worth of net flows. However, the shift was from stocks to bonds. Active equity funds lost nearly $400 billion in flows last year. Conversely, active bond funds took in $350 billion. Increasingly, that number has shifted to active bond ETFs, with the latest numbers from State Street showing active bond ETFs are increasingly getting the nod from investors.
And it’s easy to see why active fixed ETFs are getting more investor dollars.
Aside from the ability to outperform benchmarks, active ETFs’ lower costs allow managers to boost returns further and provide more yield for investors. And with yields already low, that extra boost to yield is very much welcome.
Additionally, the ability to pass off capital gains—due to the creation/redemption mechanism—and increase tax efficiency for investors is also prized. Bonds by nature are a higher tax asset class with coupon payments coming at ordinary income rates. This can be as high as 39% for investors. Any ability to lower taxes gives investors an edge on long-term performance.
The combination of these various factors supports continued growth and demand for active fixed income products. Wall Street is happy to oblige. Nearly 25 active fixed income ETFs launched last year, while several big issuers—like J.P. Morgan—have already filed to launch new active bond products.
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Growth Is Assured
The end all, be all is that active fixed income ETFs can provide a ton of benefits for portfolios big and small. With the current inflationary/rising interest rate environment and limitations on fixed income bond indexes now known, active management in the space has the ability to shine. The best part is investors have started to take notice. Fund flows into active fixed income—particularly exchange traded funds—should continue to be swift as these products have the goods to improve results and returns. For both investors and fund sponsors, this is a win-win.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.