The advantage of active fixed-income management

Geopolitical risk, aggressive central bank policy, and economic uncertainty have created volatility within both equity and fixed-income markets over the last several years, yet ETFs have continued to see net inflows. Canadian ETF assets have recently crossed the $500 billion milestone, and fixed-income ETFs saw more than $12 billion¹ in net inflows during the first half of the year.

The Canadian ETF marketplace has long been a source of innovation, including the world’s first fixed-income ETF. This development revolutionized bond investing by offering investors broad exposure to the fixed-income market in a liquid and transparent way. Since then, the number of fixed-income ETFs, both passive and active, has grown exponentially.² Currently, over 60% of the fixed-income ETFs available to investors are classified as active ETFs.³

Recently, investors have shown increased interest in gaining exposure to active management while simultaneously receiving the benefits of the ETF structure. As of the end of August, active ETFs have attracted net inflows of nearly $14 billion, outpacing last year’s flows through the same period.⁴

Rising rates have sparked bond volatility

One factor contributing to the rapid growth of active fixed-income ETFs is the shifting interest-rate backdrop. Canadian 10-year government yields have broken out of a downtrend that has been in place for decades, rising to 2.9% as of mid-September⁵ since bottoming in September 2020.

While rising yields can benefit investors who are now able to take advantage of higher income, they’ve also led to a higher degree of volatility within the Canadian bond market. 

How can active fixed-income ETFs add value?

Since active fixed-income ETFs aren’t required to track the benchmark, they can provide advantages over passive index ETFs, including better risk-adjusted performance potential, active sector rotation, and bottom-up security selection. These strategies can help manage portfolio risk while enhancing returns, particularly when fixed-income volatility remains elevated.

It’s important for investors to understand that passive fixed-income ETFs may present unexpected risks. Fixed-income indexes are debt-weighted, meaning that passive ETFs are often exposed to the most indebted companies or governments. This can lead to changes in the composition of the underlying index, along with the ETFs that closely follow the reference index.

For example, the composition of the bond market has shifted over time, leading passive, index-linked core approaches to become more concentrated in lower-quality issues. Over the past 10 years, the weight of BBB-rated bonds within the FTSE Canada All Corporate Bond Index has increased from around 25% to nearly 40%.

As this allocation grows, investors in passive ETFs tracking this benchmark might face additional risk due to the index’s inability to hold below-investment-grade securities. If a significant credit occurred, BBB-rated companies could be downgraded to high-yield status, forcing passive ETFs to sell these securities at the worst possible time.

While investors may be tempted to take advantage of the attractive income opportunities that are available to them within these lower-quality bonds, they should recognize that there is often a trade-off between yield and downside risk. Allocating a larger portion of a fixed-income portfolio to lower-quality securities can heighten drawdown risk should a recession occur and default rates begin to increase.

Finding pockets of potential opportunity

Another key aspect of active portfolio management, as opposed to passive fixed-income ETFs, is their ability to identify and exploit pockets of value in the market through thorough credit analysis. It requires a comprehensive evaluation of factors such as company performance, financial indicators, and market outlook. By carefully assessing these variables, investors can identify securities with the potential to deliver strong returns.

An example of notable variations in credit spreads among companies in the same industry can be seen when comparing Rogers Communications to BCE Inc. It shows that Rogers’ credit spread began to widen relative to BCE following its announcement in March 2021 about acquiring Shaw Communications.

This period saw increased volatility due to uncertainties around the acquisition, regulatory concerns, a major service outage, and internal conflicts. Nonetheless, active managers who adopted a strategic approach may have been able to predict a narrowing of the spread, a trend that has continued from August 2020 to the current day, unlike passive investors who would have simply tracked the index.

Examples of active funds adding value to portfolios

We can see that actively managed funds have demonstrated their ability to outperform the index by looking at rolling five-year returns comparing the benchmark to the peer group. Throughout much of recent history, the FTSE Canada Universe Bond Index has seldom ranked within the top half of the peer group and has often found itself in the bottom quartile.

How active fixed-income ETFs can help

Investors who consider opting for actively managed fixed-income ETFs can benefit from portfolio management teams that consider yield in conjunction with duration, credit quality, and sector allocation. Combined with fundamental research to support selection of specific issues, portfolio managers can be nimble and adjust the portfolio to the prevailing market environment.

However, investors should be cognizant of the limitations of active fixed-income ETFs as well. These types of funds are likely to exhibit higher tracking error and investors should be sure that they understand how the portfolio is positioned and likely to perform in differing market environments.

Looking ahead, we believe that this shift toward active ETFs will continue, particularly within fixed income, where experienced portfolio management teams can help to manage risk while potentially adding value over time.

1 Bloomberg, July 2024. 2 Why are active ETFs everywhere in Canada?, Morningstar, December 2023. 3 ETF Market Canada, as of 8/2/24. 4 ETFGI, September 2024. 5 Marketwatch.com, 9/16/24.