Fixing fixed income: How active ETFs can improve traditional passive approaches

Passive bond ETFs aim to provide representative market exposure, but inadequate market data means they may not deliver what they promise. Active ETFs could be a more effective solution.

The core purpose of exchange-traded funds (ETFs) is to allow any investor – whether an individual or a large institution – to implement their chosen asset allocation quickly and efficiently. In the complex world of fixed income, the arrival of bond ETFs has been welcomed, particularly by non-specialist investors like multi-asset funds and smaller institutions.

In many respects they’re a success, delivering low-cost exposure and gathering significant assets under management. However, when it comes to the most critical aspect – providing accurate and representative market exposure – passive bond ETFs often miss the mark. Investors aren’t getting the kind of exposure they think they’re getting, and the issue boils down to data.

Creating an investable index involves two key decisions: how to select securities and how to weight them. The goal is to create a portfolio that is both representative and liquid. In equity markets, this is relatively straightforward. Trading volume data is readily available as a measure of liquidity while market capitalisation – though imperfect – provides an adequate gauge of a company’s importance in the market.

In fixed income, indexation is much more difficult. Broad benchmarks typically comprise not hundreds but thousands of securities, making efficient replication a challenge. For example, Bloomberg’s Euro Corporate Bond Index includes over 3,500 bonds. However, the real problem is how those bonds are selected and weighted. Most indices rely heavily on issue size and/or the amount outstanding because this is the data that’s readily available. Even “liquid” indices, designed to be easier to replicate, use these metrics to select the largest bond issues. But unfortunately, availability isn’t the same thing as relevance.

Using issuance size as a proxy for liquidity is deeply flawed. In reality, large institutional investors often buy bonds in the primary market and hold them to maturity. As a result, true liquidity is fragmented and can’t easily be captured by index rules. Similarly, weighting securities by the amount of outstanding debt has long been criticised. It rewards more heavily-indebted issuers, which can distort exposure. More generally, it is being used as a stand-in for market data that simply isn’t available. This makes passive replication in fixed income inherently imprecise.

In the complex world of fixed income, the arrival of bond ETFs has been welcomed.

Specialist fixed income managers are aware of these limitations. Much of the imperative for active management in fixed income isn’t outperformance but accuracy.  Outperformance is a nice-to-have, but the primary challenge is to accurately reflect a market that isn’t well-defined by standard data points and where liquidity is hard to measure. Solving this problem requires extensive resources, technology and systems to generate deep market insights and the resources and technology to properly analyse and understand complex markets. Solving this problem requires sophisticated systems and visibility across and within bond markets – resources typically found in large asset managers with a significant market presence.

Loans and CLOs now represent a growing share of global debt markets, meaning it’s increasingly important to include them in diversified portfolios. CLO indices are now available but passive ETFs haven’t sprung up to meet investor demand. In fact, all CLO ETFs are actively managed. The data, systems and due diligence needed to properly understand and compare CLOs are beyond the scope of what index and market data providers can offer. What’s more, a passive approach would tend to reflect dealer inventory (bonds that a bond dealer holds in their own account for trading purposes), with no consideration of manager concentration and other portfolio risk factors.

The challenges of indexation don’t just affect the more esoteric corners of the bond market. Even the most basic building blocks of a fixed income portfolio could benefit from an active approach based on deep market insights.

If the goal is to reflect a market that doesn’t conform well to traditional indexing, active ETFs can provide a more accurate and effective solution.

The challenges of indexation don’t just affect the more esoteric corners of the bond market.

The views presented are as of the date published. They are for information purposes only and should not be used or construed as investment, legal or tax advice or as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security, investment strategy or market sector. Nothing in this material shall be deemed to be a direct or indirect provision of investment management services specific to any client requirements. Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, are subject to change and may not reflect the views of others in the organization. It is not intended to indicate or imply that any illustration/example mentioned is now or was ever held in any portfolio. No forecasts can be guaranteed and there is no guarantee that the information supplied is complete or timely, nor are there any warranties with regard to the results obtained from its use. Janus Henderson Investors is the source of data unless otherwise indicated, and has reasonable belief to rely on information and data sourced from third parties. Past performance does not predict future returns. Investing involves risk, including the possible loss of principal and fluctuation of value.

Not all products or services are available in all jurisdictions. This material or information contained in it may be restricted by law, may not be reproduced or referred to without express written permission or used in any jurisdiction or circumstance in which its use would be unlawful. Janus Henderson is not responsible for any unlawful distribution of this material to any third parties, in whole or in part. The contents of this material have not been approved or endorsed by any regulatory agency.

Janus Henderson Investors is the name under which investment products and services are provided by the entities identified in Europe by Janus Henderson Investors International Limited (reg no. 3594615), Janus Henderson Investors UK Limited (reg. no. 906355), Janus Henderson Fund Management UK Limited (reg. no. 2678531), (each registered in England and Wales at 201 Bishopsgate, London EC2M 3AE and regulated by the Financial Conduct Authority), Tabula Investment Management Limited (reg. no. 11286661 at 10 Norwich Street, London, United Kingdom, EC4A 1BD and regulated by the Financial Conduct Authority) and Janus Henderson Investors Europe S.A. (reg no. B22848 at 78, Avenue de la Liberté, L-1930 Luxembourg, Luxembourg and regulated by the Commission de Surveillance du Secteur Financier).

Outside of the US: For use only by institutional, professional, qualified and sophisticated investors, qualified distributors, wholesale investors and wholesale clients as defined by the applicable jurisdiction. Not for public viewing or distribution. Marketing Communication.

Janus Henderson is a trademark of Janus Henderson Group plc or one of its subsidiaries. © Janus Henderson Group plc. D10520