Active, active, active! Everywhere we turn, we are hearing that a new dawn is upon us, and it is once again the time for active management. Many would be surprised that I totally agree. As outlined in my 2023 predictions, one could argue the decade of “cheap” money and record-low interest rates has passed, and those skilled enough to navigate these volatile markets will certainly do well.
However, it’s a much brighter dawn that we see on the horizon—the dawn of active fixed income in the exchange-traded fund (ETF) vehicle. It is a myth to still assume that ETFs are solely passive vehicles. ETFs are forever evolving to help address developing investor needs, and asset managers now offer a range of ETFs, from passive, to thematic, alternative index-weighted (factor investing) and yes, also active.
As the opportunity for active management returns, it’s clear to us that active ETFs—and in particular active fixed income ETFs—should see significant growth. But why? Why are we so bullish on active fixed income in the ETF wrapper?
Let’s begin with a refresher on the basics.
What is an active ETF?
As mentioned, ETFs have evolved. Traditional ETFs track market capitalisation-weighted indices with, for example, thematic ETFs (which have garnered so much recent investor interest) often following this methodology. Market-cap weighted indices are backward-looking, reflecting stocks or bonds that have performed well in the past—rather than looking at a potential opportunity.
Hence, while no active decisions are made with a traditional passive ETF, a “style” bias and factor or factors are embedded. For market-cap-weighted strategies, that factor is essentially price-earnings momentum, or “buying the winners and selling the losers.”
Active management is combining this and other styles with fundamental analysis and having full discretion on the universe of stocks or bonds in an effort to beat a benchmark, rather than having the constraints of tracking an index. This means an active manager can choose which stocks or bonds to buy, when to buy them and at what size/price.
In an effort to outperform its portfolio index, fund managers can actively respond to market events and adjust allocations amid changing market environments. In some instances, they even have some leeway to invest outside the confines of their benchmark index.
So, an active ETF resembles a traditional actively managed mutual fund, but the ETF vehicle trades on an exchange with the perceived benefits of the ETF structure.
ETFs change the fixed income market structure
We think an ETF’s benefits are magnified when applied to the fixed income asset class.
For some investors, bond markets historically have been rather opaque. The fixed income market and market structure have tended to be bought and sold over the counter (OTC). In other words, a buyer and a seller agree on a price bilaterally outside of any central exchange, in contrast to equity investments, which primarily trade on exchange. This opaque bond market structure limits natural liquidity and price discovery. However, the ETF wrapper not only opens access to this asset class, but also democratises its price discovery—and it is the only fund vehicle to do this on an intra-day basis.
Until recently, only larger or institutional investors have had access to bond wholesalers. And unlike these larger counterparts, some investors may have less expertise in the basics of bond trading. They may also lack access to large dealer networks for quotes in order to shop around for the best available prices. Mutual funds have traditionally been a popular choice for many wealth managers, independent financial advisors or retail investors looking for exposure to fixed income assets.
While a mutual fund may be sufficient for many investors, others might be looking for alternatives that offer access to features like intra-day pricing, trading, and downstream monitoring and risk analytics, for example.
The evolution of ETFs, particularly in the fixed income arena, can deliver on some of those needs, offering retail investors access to a market with the same price discovery/transparency as their institutional counterparts.
The importance of price transparency
The fact that the ETF wrapper has taken a largely off-exchange, over-the-counter-(OTC) driven asset class and democratised its price discovery is important to point out. Price transparency underpins the efficiency and fairness of all financial markets.
Transparent markets promote more efficient and cost-effective trading and, in turn, higher levels of investor confidence and participation.
A case in point
Let’s remind ourselves of how fixed income ETFs brought all of the above-mentioned attributes to the surface and illustrated these tangible benefits to help investors navigate heightened volatile markets.
The dislocations and volatility seen in global markets at the onset of the COVID-19 pandemic pointed to an ever-more pressing case to utilise ETFs for all of the above-mentioned benefits. In particular, the liquidity and transparency in heightened volatile periods. At the height of the pandemic-driven volatility, some critics suggested that ETFs—in particular fixed income ETFs—were causing dislocations in the bond market, and many fixed income ETFs were wrongfully trading at a discount to the net asset value (NAV) of those respective funds.
However, to fully appreciate why this is an inaccurate assessment, it’s worth taking a step back and appreciating the different market microstructures between fixed income (bonds) and equity securities (stocks). As mentioned, trading in the bond market is still driven primarily by the over-the-counter (OTC) market, where parties trade directly, off exchange.
In extremely volatile periods, fixed income ETFs (which do trade on exchange) may sometimes trade away from the NAV of their underlying index. This is because the NAVs are often calculated based on delayed prices, not on real-time executable prices which ETF market makers can take action on.
However, what we saw during the volatile pandemic period was how fixed income ETFs actually give clients actionable price discovery and on-exchange transparent pricing within the traditionally OTC-driven asset class, and it’s now clear many investors appreciate how ETFs are intended to work.
Let’s take the scenario just mentioned of a fixed income ETF trading intraday at a discount to the ETF NAV. Firstly, the accurate intraday pricing illustrates the intraday liquidity the ETF wrapper offers. While we saw markets down percentages intraday during that period, the ability to trade fixed income holdings in a fund in real time illustrates the ETF’s ability as a valuable tool in liquidity management.
The second component is transparency. While ETFs are transparent via daily holdings disclosures, this scenario also points to transparency around execution. As highlighted earlier, the ability of ETFs to be marked-to-market intraday and for ETF market makers to accurately price the underlying basket and offer accurate bid/offer (buy and sell) prices in real time gives investors full transparency around their costs of execution, and in volatile times, the extra cost for the same execution.
The third attribute is cost efficiency. Again, while the efficiency of the ETF wrapper helps keep total expense ratios to a minimum, this scenario also points to cost efficiency for all types of investors—whether they want to direct assets towards a new ETF investment, sell out of an existing one, or maintain their current portfolio. As we’ve outlined, the ETF’s ability to accurately price the underlying basket ensures incoming/outgoing investors accurately pay for entering/exiting a fund independently. As a result, ETFs keep costs independent and fully transparent, helping to ensure existing shareholders are not penalised by new investor flows. Additionally, the executable transparency for incoming/outgoing investors is always preserved, even while underlying markets are experiencing times of stress.
We think active ETFs—and fixed income in particular—represent an area of continued growth for the ETF market in Europe. We expect to see more products and assets down the line. Investors are seeing the benefits of active management, especially when markets are turbulent.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Generally, those offering potential for higher returns are accompanied by a higher degree of risk. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets.
For actively managed ETFs, there is no guarantee that the manager’s investment decisions will produce the desired results.
ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.
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