Active fixed-income ETFs take ‘passive’ portfolio construction to new heights

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For financial advisors and investors, the past decade has been about adjusting to the ‘new normal’ in portfolio construction.

Facing lower yields from fixed income, many portfolios have undergone a facelift as investors looking for greater returns jumped from safe, low-return, fixed-income instruments to riskier, higher-yielding bonds or dividend-paying stocks.

“The fixed-income portion of the portfolio has become much more complicated – to say the least,” says Ahmed Farooq, vice-president of exchange-traded fund (ETF) business development at Franklin Templeton Investments in Toronto.

Even for advisors, building this life preserver part of the portfolio has been challenging, particularly when it comes to convincing clients they need fixed income after more than a decade of rising equity markets and morose bond returns.

“It’s not an easy game,” says Edward Jong, a fixed-income portfolio manager with T.I.P. Wealth Manager Inc. in Toronto.

He notes among the challenges for fixed income is the low return environment globally, in which European and other nations have issued more than $11-trillion in bonds with negative yields.

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“If rates are kept low, where does one look to generate extra income?” Mr. Jong asks.

Traditional portfolio construction is “predicated heavily on modern portfolio theory and the advantages of diversification” and does not necessarily work like it did more than a decade ago, says David Andrews, vice-president and client portfolio manager at Franklin Templeton Investments in Toronto.

The diversification and risk-reducing benefit of adding bonds to equities has weakened. That means investors will need to start considering their options when seeking the safety cushion fixed-income investments provide.

While Canadian and U.S. fixed-income yields aren’t yet negative, they’re still losing propositions after inflation and taxation.

However, a strong argument can be made that investors’ portfolios need greater exposure to fixed income today more than ever. As Mr. Farooq notes, it’s more than likely many portfolios are out of balance from their original investment goals.

“In the 10 years of this reigning bull market, a lot of investors lost focus on the fixed-income exposure just because equities were up,” he says.

Moreover, if investors were buying fixed income, it was often “higher-octane” bonds, Mr. Farooq adds.

Most advisors acknowledge fixed income’s value as a portfolio cushion, padding against equities’ downside; driving that point home to clients is another matter, though.

“You have to do a lot of education,” says Adrian Mastracci, discretionary portfolio manager at Lycos Asset Management Inc. in Vancouver.

Specifically, he says he must explain to clients often that fixed income is necessary, albeit bitter, medicine for long-term portfolio health.

“Sometimes, when you look at the [fixed-income] returns you just have to hold your breath and carry on. That’s what I tell my clients,” he says.

Mr. Mastracci uses several portfolio management tools to get better fixed-income exposure, including individual bonds, guaranteed investment certificates and ETFs.

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But it’s ETFs that have been a game-changer for bond investing in the past decade, with investors happy to take what a low-cost, diversified passive strategy gives them.

While that’s worked well over the past 10 years, a passive strategy may not be as rewarding over the next decade, Mr. Andrews says.

For example, a Canadian bond ETF that tracks a benchmark index by design will be affected, inevitably, by Canada’s large energy sector, which remains mired in a slump. That may pose more risk than advisors and investors are comfortable with going forward.

That’s where a new breed of ETFs may prove their worth. They’re actively managed with low management expense ratios (MERs) that look beyond traditional ETF investing.

Active ETFs start by tracking a benchmark index and a portfolio manager has the flexibility to deviate from the designated index or sector allocations to achieve alpha – better returns – based on their analysis.

These fund managers have the greenlight to adjust their portfolios tactically in response to events such as monetary policy changes, geopolitical events, interest rate changes or more – all of which can make fixed-income investments tougher to navigate.

Truly active portfolio managers also have the tools and the research capabilities to select bonds properly in an effort to help deliver better investor outcomes, while a passive portfolio manager has to match the fundamentals of the benchmark index.

This new generation of ETFs might involve, for example, providing broad exposure to Canadian government and blue-chip corporate bonds while leaving a significant allocation – say, up to 30 per cent of the portfolio – “designed to fill gaps that are not fulfilled in the Canadian bond marketplace … with investments that are off the Canadian benchmark,” Mr. Andrews explains.

That allocation might include high-yield U.S. bonds and short-term bank loans to generate a positive real return in the fixed-income allocation of the portfolio, he adds.

Or, an actively managed global bond ETF might still be “benchmark aware” providing, for example, diversified exposure based on the Bloomberg Barclays Global Aggregate Index, but with a “fundamental screen on top,” Mr. Farooq says.

As such, the fund manager can underweight geographical allocations on the benchmark, which have negative yields and instead overweight “other countries with a positive outlook,” he says.

Also noteworthy is that actively managed ETFs can come with management fees that are competitive with those of passive products.

“It’s never been cheaper to get diversified exposure to bonds in the portfolio,” Mr. Andrews adds.

Put another way, advisors and even do-it-yourself investors don’t have to go it alone constructing the fixed-income portion of the portfolio unless, of course, they want to.

“For the most part, advisors are more comfortable with the equity side of the equation but some less comfortable managing the uncertainty we have with fixed-income market going forward,” Mr. Andrews says.

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