include more than 1,200 ETPs across a number of different asset classes. More and more investors have embraced the exchange-traded structure as a vehicle for achieving exposure to fixed income; according to the ETF screener there are more than 160 bond ETFs covering every imaginable corner of the fixed income market, from convertible bonds to high yield munis and even Latin American debt.
The appeal of utilizing ETPs within the fixed income portion of a portfolio is relatively straightforward; ETFs offer competitive expense ratios, intra-day liquidity, and potential tax efficiencies. But there are some potential pitfalls that should be considered when using index-based ETFs to achieve bond exposure.
Bond ETFs are somewhat unique in that the investor experience varies considerably from holding individual bonds. Whereas an investor who buys a bond will experience a maturity event that results in the return of principal, most bond ETFs are designed to operate indefinitely. That means that most bond ETFs maintain a relatively constant duration (and therefore constant interest rate risk) and will potentially operate indefinitely without returning principal (investors, of course, have the opportunity to sell shares of the ETF at any point).
Innovation in recent years has provided investors with bond ETF options that behave more like ‘regular’ bonds; Guggenheim offers suites of target end date corporate and junk bond ETFs, while iShares maintains a similar lineup of muni bond ETFs [see Are Bond ETFs Broken?]. While these products can be effective tools for addressing some of the potential shortcomings of fixed income ETPs, there are other nuances of indexed bond products that some investors have found disconcerting:
The indexes to which many bond ETFs are linked have been around for decades, and simply weren’t designed to be replicated by investable securities. For example, the Barclays Capital U.S. Aggregate Bond Index, to which ETFs with aggregate assets of more than $20 billion are linked, consists of approximately 8,000 individual bonds. Many of the index components are illiquid and trade irregularly, making complete replication a challenging task. The iShares Barclays Aggregate Bond Fund (NYSE:AGG), which has about $11 billion in assets, holds only about 10% of the total number of holdings. This “sampling” strategy is implemented to come up with a portfolio exhibiting similar risk/return characteristics of the broader benchmark, and generally accomplishes the stated objective efficiently.
Front running risks are often mentioned as one of the potential hurdles to widespread adoption of active ETFs, but this phenomenon must be considered in the passive ETF arena as well. Because many fixed income ETFs maintain specific maturity windows, it is relatively easy to predict when those funds must buy or sell certain securities. For example, the trading activity of the Barclays Capital 3-7 Year Treasury Bond Fund (NYSE:IEI) is no secret, potentially creating opportunities for savvy investors to load up on securities that are coming into the window and get out of bonds that they know the IEI managers will shortly be selling.
It should be noted that even broad-based bond ETFs maintain “minimum maturity rules” that predictably impact the composition of their portfolios. AGG and the competing Vanguard Total Bond ETF (NYSE:BND), for example, are linked to an index comprised of bonds that have at least one year remaining to maturity. That means that these funds will often be selling big quantities of bonds that are within a year of maturity, putting downward pressure on prices and potentially eroding bottom line returns.
In the equity space, interest in products that offer alternatives to cap-weighting has intensified in recent years. While cap weighting maintains some advantages, there are potential drawbacks as well–most notably the tendency to overweight overvalued stocks and underweight undervalued ones.
Many bond indexes introduce similarly undesirable biases. Since most fixed income benchmarks are cap weighted, they have a tendency to give the biggest weighting to the biggest debtors. As the debt obligations of the U.S. government have grown in recent years, the allocation to Treasuries in AGG and BND has climbed. In corporate bond funds, the consequences of this methodology may be more troubling; companies with the biggest debt burdens get the biggest allocation in the benchmarks underlying many ETFs, potentially resulting in a tilt towards riskier debt issues.
“When you think about capitalization weighting in stocks the drawbacks are fairly evident,” said Research Affiliates founder Rob Arnott in an interview with ETF Database last year. “When you talk about cap weighting in bonds, the drawbacks are flagrantly obvious.” Those drawbacks have the potential to weigh on the performance of bond ETFs over the long run, and are a major reason why some investors have been hesitant to make the switch to ETFs for their bond exposure.
Active Bond ETFs: A Better Option?
While actively-managed equity ETFs have generally been slow to catch on with investors, a number of active bond funds have seen significant interest. That’s likely a result of lingering concerns over the issues highlighted above; while investors may prefer indexing strategies in asset classes known to be highly efficient (such as large cap U.S. stocks), there may be a greater level of comfort with an experienced manager in areas where liquidity issues can be difficult to navigate and rules-based methodologies can lead to inefficiencies in portfolio management.
The flexibility afforded by active management of a bond fund will generally allow for the avoidance of the issues highlighted above. The lack of a target index eliminates the need for sampling strategies that inherently call for manager discretion anyways, and eliminates the predictable trading patterns that are associated with any maturity window. And of course there is no requirement to increase exposure to any one issuer based on the size of the relevant debt burden; managers are perhaps more likely to implement a strategy opposite of that methodology.
Active bond ETFs still offer all of the advantages of the exchange-traded structure that their passive counterparts provide. While actively-managed funds are slightly more expensive, they are generally far cheaper than comparable mutual funds thanks to the reduced administrative functions required of ETPs. The Guggenheim Enhanced Core Bond ETF (NYSE:GIY), for example, charges just 0.27% annually–roughly in line with the passive AGG (0.24%) and well below the fees charged by most fixed income mutual funds [see Active ETFs vs. Mutual Funds: Highlighting Critical Differences].
Active bond ETFs allow for flexible intraday trading in exactly the same way that passive funds do, and the inherent tax advantages of the exchange-traded structure remain as well. So it is perhaps no surprise that most of the growth in active ETFs has been on the bond side of the market, where many investors are clearly aware of the potential pitfalls of indexed bond funds and more comfortable utilizing a management team with the flexibility to avoid certain biases.
Active Bond ETFs
There are a number of actively-managed bond ETFs currently available to investors, including broad-based funds and more targeted products focusing on high yield debt and international securities.
Active Total Bond ETFs
Guggenheim and Columbia both offer total bond market ETFs that deliver broad-based exposure to the U.S. investment grade bond market (including Treasuries and investment grade corporates):
- Guggenheim Enhanced Core Bond ETF (NYSE:GIY)
- Columbia Core Bond Strategy Fund (NYSE:GMTB)
Active Short Term ETFs
For investors looking to achieve money market-like exposure, there are multiple active ETFs focusing on short-term, high quality debt instruments:
- Guggenheim Enhanced Ultra-Short Bond ETF (NYSE:GSY)
- PIMCO Enhanced Short Maturity Strategy Fund (NYSE:MINT)
- PowerShares Active Low Duration Fund (NYSE:PLK)
Active Muni Bond ETFs
Investors looking to achieve exposure to municipal bonds have several active ETF options available to them, including both broad-based ETPs and duration-specific funds:
- Columbia Intermediate Municipal Bond Strategy Fund (NYSE:GMMB)
- PIMCO Build America Bond Strategy Fund (NYSE:BABZ)
- PIMCO Intermediate Municipal Bond Strategy Fund (NYSE:MUNI)
- PIMCO Short Term Municipal Bond Strategy Fund (NYSE:SMMU)
Active International Bond ETFs
The universe of active bond ETFs isn’t limited to the U.S., as WisdomTree offers a pair of actively-managed funds with an international focus:
- Asia Local Debt Fund (NYSE:ALD)
- Emerging Markets Local Debt Fund (NYSE:ELD)
Active High Yield Debt ETF
AdvisorShares offers an actively-managed alternative to junk bond ETFs such as (NYSE:JNK) and (NYSE:HYG):
- Peritus High Yield ETF (NYSE:HYLD)
Written By Michael Johnston From ETF Database Disclosure: No positions at time of writing.
ETF Database is committed to giving our audience, consisting of both active traders and buy-and-hold investors, information that, to our knowledge, is truthful and non-biased. [For more ETF insights, sign up for our free ETF newsletter or try a free seven day trial of ETFdb Pro .]