July 28, 2022

    ETF Insider

    Welcome to this week’s ETF Insider. With the Federal Reserve again jacking up interest in effort to tackle inflation, it’s a perfect time to dig into fixed-income ETFs. We’ll look at how to put the bond market pounding in perspective for clients.

    First, we’ll parse a Vanguard piece that describes how rising interest rates have hit the returns of one of its bond index ETFs, but driven yields on the product higher. It’s a good time to remind clients that, over the long run, higher interest rates translate into more income for bond-fund shareholders – even if it means some pain in the short-term, Vanguard says. Other managers seem to agree with the principle.

    Active managers aim to take advantage of some of the turmoil and beat the battered benchmarks. Investors can now access bond-picking strategies in nearly every major segment of the fixed-income market via the ETF wrapper, a new white paper indicates. Portfolio mangers seem more comfortable with the transparency elements of active bond ETFs. Perhaps more importantly, they seem to be able to beat their passive fund rivals even after fees, the report notes.

    Thanks, as always, for reading this newsletter. Reach out at editorial@financialadvisoriq.com

    Jackie Noblett, producer of ETF Insider at Financial Advisor IQ

    Sharp Rate Rise Stings in the Short Term, but the Big Picture Looks Brighter: Shops

    It’s been a long time since investors have needed to cover their eyes when it comes to bond-market returns. The Bloomberg U.S. Aggregate Bond Index’s 10.7% drop marked the worst first-half performance since the Ford Administration.

    A lot of this has to do with the big move in the federal funds rate, which went from near-zero mere months ago to 2.25% following Wednesday’s Federal Open Market Committee meeting. The central bank’s move drives yields on bonds up and their prices down, which may feel like a punch in the gut for what is supposed to be a stable segment of client portfolios. But several managers are reminding advisors and investors that rising rates are good – in the long run – for clients hoping to generate income from their bond holdings.

    Vanguard on Monday published an analysis of how rising fed funds rates impact its $14.8 billion Vanguard Short-Term Treasury ETF (fed rate hikes tend to have the most direct impact on the short end of the yield curve.) As the two-year Treasury yield spiked from 0.48% in October to 2.53% in May, the fund’s so-called SEC yield similarly ballooned from 0.34% to 2.53%. (The SEC yield is the calculation favored by the regulator that measures the yield on the bonds in the portfolio over the last 30 days, when they are held to maturity.)

    However, the ETF’s distribution yield – which reflects the yield investors currently are getting on distributions – has only nudged up from 0.28% to 0.57%. Meanwhile, the ETF has returned -3% year-to-date through June.

    But Vanguard reminds advisors that it takes time for rising yields to show up in distributions, as the older, lower-yielding bonds roll off at maturity and are replaced by higher-yielding ones. More importantly, this increased yield will give investors a higher total return over time.

    “It’s not that changes to a bond’s price don’t matter. They matter a lot more than yields do in the short-term,” Vanguard writes. “But price changes matter less to client outcomes over the longer haul.”

    The Malvern, Pennsylvania-based fund giant is not the only manufacturer to make the argument for bond ETFs in this market. “I know that people that are long fixed income don’t like to see rising rates,” BlackRock President Rob Kapito said on the firm’s second-quarter earnings call last week. “However, with this environment, it’s actually going to be a good thing for many institutions who need fixed income in their portfolios to meet their long-term goals.”

    The firm expects the upheaval to attract more first-time ETF users and prompt established users to allocate more to ETFs as they reposition portfolios. Investors poured $31 billion into BlackRock’s bond ETFs, globally, in the second quarter. That compares with $23 billion in the firm’s equity ETFs.

    Indeed, this may be why fixed-income ETFs continue to attract significant assets across the industry─ $150.4 billion year-to-date through July 22, according to FactSet – despite the turmoil. Investors still need income, and low-cost bond ETFs are an appealing way to access it.

    Active Bond ETFs Reach Critical Mass: Report

    Much of the money invested in bond ETFs sits in big, highly liquid products that track broad benchmarks, whether the Bloomberg U.S. Aggregate Bond Index or a broad-based government, investment-grade or high-yield corporate measure. But active management now has a solid foothold in fixed-income ETFs, a new report indicates.

    Broad availability, combined with strong after-fee relative performance, could make active bond ETFs an attractive option for investors seeking to navigate the choppy markets, the TrackInsight report adds.

    Active managers’ share in fixed income ETFs, globally, has grown from less than 1% in 2009 to more than 10% at the end of last year. That puts the market at roughly $169 billion, according to a recent report from the ETF data provider. U.S.-listed funds represented more than 80% of those assets, or $153.3 billion. And 88% of the 348 products were available globally.

    America stands out not just because of the size of the active ETF market, but also the diversity of active strategies available through the wrapper, TrackInsight notes. All types of issuers – from government to corporate to municipal – and types of bonds – whether fixed-rate, floating-rate or inflation-protected, are covered in active ETFs. Active environmental, social and governance-focused ETFs, meanwhile, represented some $3 billion at the end of 2021.

    Notably, some of the largest providers of active bond ETFs are not the same players that dominate index-based fixed-income, namely iShares, Vanguard and State Street. First Trust, JPMorgan Asset Management and Pimco represented 47% of active bond ETF assets at the end of last year, with 12% of the market held in just one product: the JPMorgan Ultra-Short Income ETF.

    This diversity is important as investors try to respond to a fast-changing bond market where many have felt less comfortable navigating, TrackInsight argues.

    “Fixed income is a complicated asset class comprised of many different types of instruments often misunderstood, even by professionals. Many investors do not want or have time to study the economic environment,” the report notes. “Active fixed income ETFs allow investors to let experts in fixed income optimize their investments in their place.”

    Bond investors have another reason to like active management, TrackInsight argues: they perform well, even after accounting for fees.

    Active fixed-income ETFs, globally, charged on average 75 basis points in net expenses last year. That is just shy of triple the average index bond ETF, which charged 26 bps, according to TrackInsight’s data. But the average active fixed income ETF returned 5 bps in 2021. The Vanguard Total Bond Market ETF, by comparison, posted a decline of 2.31%. And the 10 largest active bond ETFs all outperformed the broad-based index ETF benchmark.

    Of course investors can – and data indicates, increasingly do – use index-based ETFs to actively manage the fixed-income part of their portfolios, including by leaning on bond-specific model portfolios. Index ETFs provide liquidity and access to the bond market in a way that, for your average advisor, individual bond issues would be too costly.

    But for advisors who feel more comfortable leaning on active managers’ expertise, there seem to be a critical mass of ETFs available to build a diversified bond portfolio.