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Advocating for active

When investors hear “ETF,” they tend to think passive. That’s easy to understand given the spectacular growth of assets in passive strategies, particularly those in equity-focused ETFs. But before jumping to conclusions, let’s check the thesaurus. “Passive” and “ETFs” need not be synonyms. There’s an entire world out there of actively managed ETFs, and this active approach seems particularly well-suited to the expansive world of fixed income investing. 

Actively managed fixed income ETFs provide investors with the potential advantages of the ETF wrapper—lower costs, liquidity, intra-day trading, transparency, tax efficiency—while also giving the manager some wiggle room to deviate from its bond benchmark. And in a world starved for yield where every basis point counts, actively managed fixed income ETFs may appear to have a better chance to boost yield, manage risk, and ultimately improve investor outcomes.

Some history

A case for an active fixed income strategy can be made from a deeper understanding of the best-known bond benchmark, the Bloomberg Barclays US Aggregate Bond Index (the “Agg”), which is widely used to track the U.S. investment-grade bond market. The earliest version of the Agg actually dates to two separate bond indexes in early 1970s, which were later combined and maintained by now-defunct Lehman Brothers. Today, the Agg has been rebranded by Bloomberg Barclays and includes Treasuries, government agency bonds, mortgage-backed bonds, corporate bonds, and some foreign bonds traded in the U.S.

Though the Agg offers an impressive cross-section of securities, it is somewhat hampered (some would say flawed) by its very structure since it is weighted based on the amount of issuance outstanding. In other words, weights within the index and the subsequent influence on performance are tilted to the largest debtor companies. That might not be such a good thing. History is replete with large bond issuers—often name-brand companies bloated with debt—defaulting. In the 1970s, utilities were often culprits. The bubble and the Global Financial Crisis engendered defaults among tech, housing and financial services companies. And energy companies have taken their turn in this notorious spotlight.

In its purest iteration, a passive fixed income strategy would be forced to hold dubious securities until they dropped out of the index. By then, the damage would be done. However, with a deeper fundamental analysis and better risk protocols, an active manager could (in theory) either avoid them or cut his or her losses. Along those same lines, the Agg is permitted to hold only investment-grade securities, so if those issues are downgraded to junk status the Agg must sell those positions by rule. In contrast, an active management team can evaluate the credit quality of any downgraded bond relative to its price and make an educated investment decision, rather than being a forced seller. 

Another criticism and possible limitation of any passive fixed income strategy that closely tracks the Agg revolves around agency mortgage backed securities (MBS), which recently constituted approximately 27% of the index. Without going too deep, the sensitivity of MBS to fluctuations in interest rates is often less favorable when compared to other fixed income securities of similar maturities. The reason has to do with how MBS are impacted by homeowner trends in refinancing their mortgages. So while the Agg has more than a quarter of its portfolio in MBS, active fixed income managers can eschew them as they see fit. 

Gaining an edge

The very structure of the bond market is also more conducive to active management. The domestic bond market is much larger than the stock market, with $40-plus trillion in a vast array of fixed income securities. It’s huge and diverse, yet the over-the counter-nature of bond trading and pricing is far less transparent than equities where securities are listed on public exchanges. 

An opaque market with more complex securities (with varying structures and call features) suggests that it’s easier to have mispricing in fixed income securities than in individual stocks. Thus, while it may be tough to get an advantage in equities (especially in large-caps), it may be easier for some bond investors to gain an information advantage through diligent credit research and better trading. In fact, size and scale truly matters for bond managers, not just in terms of trade execution, but also because it may provide greater access to the new issue market. All these factors have made it potentially more likely for active fixed income managers to outperform their benchmarks compared to their equity counterparts.

I believe that the fixed income universe is tailor made for active management, and combining it with the inherent structural advantages of ETFs is a sound approach. So while active management has become a punching bag for financial journalists, perhaps it’s time to punch back, especially if you are active fixed income manager.

©2020 Victory Capital Management Inc.
Consider the investment objectives, risks, charges and expenses of the funds carefully before investing. Download a prospectus or summary prospectus, if available, containing this and other important information for USAA Mutual Funds from, for Victory mutual funds from, or for VictoryShares and VictoryShares USAA ETFs from Read it carefully before investing.

Investments involve risk including possible loss of principal. The value of the equity securities in which the fund invest may decline in response to developments affecting individual companies and/or general economic conditions. Dividends are never guaranteed. International investing involves special risks, which include changes in currency rates, foreign taxation and differences in auditing standards and securities regulations, political uncertainty, and greater volatility. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. You may lose money by investing. There are no guarantees the funds will achieve their investment objectives and strategies may be unsuccessful.

Investments in bank loans may at times become difficult to value and highly illiquid; they are subject to credit risk such as nonpayment of principal or interest, and risks of bankruptcy and insolvency. Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

ETFs have the same risks as the underlying securities traded on the exchange throughout the day. Redemptions are limited and often commissions are charged on each trade, and ETFs may trade at a premium or discount to their net asset value. There can be no assurance that an active trading market for shares of an ETFs will develop or be maintained. The ETFs are not actively managed and may be affected by a general decline in market segments related to the Indexes. The ETFs invest in securities included in, the Index, regardless of their investment merits. The performance of the ETFs may diverge from that of the Indexes. 

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Content on Xchange, the Victory Capital Blog, is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date posted and may change as subsequent conditions vary. The information and opinions contained in each post are derived from proprietary and non-proprietary sources deemed by Victory Capital to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

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