Key Takeaways
- We’ve been seeing a lot of momentum this year in particular with active bond ETFs coming to market.
- ETFs are becoming the preferred vehicle for a lot of financial advisors and their clients, including when it comes to investing in fixed income.
- Active bond ETFs that are coming to market today are not clones per se of mutual fund strategies, but they are very similar to what is already available in mutual funds.
- Recently, we’ve seen a lot better results from active bond managers, particularly the cheapest ones. According to our latest Active/Passive Barometer, over the last 10 years, the cheapest active bond funds have outperformed passive peers in general.
- The advantages of the ETF structure when it comes to bond investing comes down to fees, transparency, and portability.
- Active bond ETFs are not as tax-efficient as active equity ETFs are.
- Before investing in active bond ETFs, ask your manager how they approach duration and credit risk. Ask the role of active bond ETFs in the portfolio—if we’re using this to diversify from the equity risk, to generate more income, or a combination of both.
Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Asset managers including Vanguard and BlackRock are launching bond ETFs that are actively managed. What are the pros and cons of active ETFs focusing on bonds? And what questions should you be asking before you buy one? Here with me to walk through the issues is Jason Kephart. Jason is a senior principal with Morningstar’s multi-assert team.
Good to see you, Jason.
Jason Kephart: Thanks for having me, Susan.
How Active Bond ETFs Have Performed With Investors
Dziubinski: Now, a few weeks ago, you and I sat down and talked about the rise of active equity ETFs, but we’ve also seen active bond ETFs coming to market. So have the active bond ETFs gained traction with investors? What’s the uptake been like?
Kephart: Yeah, we’ve actually been seeing a lot of momentum this year in particular. Even though active bond ETFs are a small piece of the overall bond ETF universe, flows year-to-date have almost been neck and neck. For active bond ETFs, it’s been about 42 billion through the end of March, versus 57 billion for passive index ETFs, bond ETFs. But generally, we’re seeing a lot more interest in this area.
Why Asset Managers Are Investing in Active Bond ETFs
Dziubinski: Oh, that’s interesting. So now why are asset managers sort of dipping a toe—or an entire foot—with active bond ETFs? Is there something special about that ETF wrapper that’s particularly useful when it comes to investing in fixed income?
Kephart: I think ETFs are just becoming the preferred vehicle for a lot of financial advisors and their clients. They’re portable, they’re transparent, they tend to be lower cost, and I think all those things really resonate. Though—I think we’ll talk about it a little later—but some of the advantages an ETF gives an equity strategy aren’t really as prevalent in fixed income, but still I think that portability, transparency, and low cost are really the key, key factors there.
Are Active Bond ETFs Following the Same Strategies as Mutual Funds?
Dziubinski: Jason, are most of the active bond ETFs that are coming to market today clones of mutual fund strategies, or are asset managers bringing new strategies to market in the ETF wrapper?
Kephart: They’re not clones per se, but they are very similar to what is already available in mutual funds. Again, it’s really just that new vehicle that’s kind of really attracting people to it.
Why Active Fixed-Income Funds Have Outperformed Passive Strategies
Dziubinski: Jason, now Morningstar research has shown that active funds tend to lag passive funds in equity categories, but our research hasn’t painted the same picture when it comes to fixed income, right?
Kephart: Yeah, recently we’ve seen a lot better results from active bond managers, particularly the cheapest ones. According to our latest Active/Passive Barometer, over the last 10 years, the cheapest active bond funds have outperformed passive peers in general. And so with active bond ETFs, that low cost is kind of built-in, so that really gives them a big advantage. So you might see strong performance from active bond ETFs going forward, too.
Advantages to Investing in Active Bond ETFs
Dziubinski: Well, that would be hopeful and great news. Talk a little bit more about the advantages of the ETF structure when it comes to bond investing.
Kephart: Yeah, and it really just comes down to fees, transparency, portability. You don’t have to worry about what’s available on a certain platform. You can access an ETF from anywhere, and you get it at a low cost for everyone. So advisors, individual investors, all paying the same fees, I think that’s another real benefit of the ETF structure that we don’t talk about enough maybe—is that they really are accessible to everyone, and I think that makes them a really advantageous head start over mutual funds.
Why Active Bond ETFs Are Not as Tax-Efficient as Active Equity ETFs
Dziubinski: Now, let’s look at the other side of this. So what would be the cons, if there are any, to active bond ETFs?
Kephart: Yeah, I wouldn’t say it’s a con per se, but they’re not as tax-efficient as active equity ETFs are, and that’s because most of the returns from bonds come from income, and there’s nothing an ETF structure can do to change that equation, and income’s going to be taxed as ordinary income no matter what. So they’re not as tax-efficient, but still they’re really good vehicles.
Ask Your Advisor These Questions Before Investing in Active Bond ETFs
Dziubinski: Got it. So let’s wrap up with some key questions that you think investors should be asking their advisors or be asking in general before they would invest in an active bond ETF. I think it’s a lot of the same questions you’d ask about any active bond manager. Why do we have conviction they can outperform?
Kephart: Obviously, the last few years, probably since 2021, have been very volatile fixed-income markets. Seen a lot of interest-rate volatility. 2022 credit was kind of challenged along with interest rates. So you want to understand—how does the manager approach duration? How do they approach credit risk? Those are kind of the key questions you really want to ask. And then also, what is the role of this in the portfolio? Are we using this to diversify from the equity risk? Are we using this to generate more income or kind of a combination of both? And really understanding that role it’s supposed to play in a portfolio, I think will help you understand how it’s going to perform over time.
Dziubinski: Jason, thank you so much for your time today. We appreciate it.
Kephart: Thanks for having me, Susan.
Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.
Watch Ask Your Advisor These Questions Before Investing in Active Equity ETFs for more from Jason Kephart.