Fixing Fixed IncomeAug 22, 2018

Last month I went to Montreal with some of my colleagues to take part in the inaugural Canadian Inside ETFs conference. It was a great event with a lot of discussion around: the rise of active ETFs, the growth story of ETFs in Canada and the future evolution of active management. One of the key themes from the event that really dominated the headlines came from my colleague Patrick O’Connor, Head of Franklin LibertyShares ETFs®. In an interview with Bloomberg during the event, he claimed “bond indexes are broken”. It quickly became a trending story generating a lot of discussion, so I thought I would share my own thoughts on the issue.

To start, when it comes to fixed income ETFs, until recently investors didn’t really have many options to choose from, so they put money primarily into passive fixed income ETFs that track a bond index. In most cases this wasn’t a big concern for investors because they were enjoying the benefits of the 35- year bull market in bonds. As a result of that bull market, fixed income portfolio managers didn’t have to worry much about managing duration in the portfolio as interest rates continued to fall. The bull market in bonds seems to be coming to an end now that the Federal Reserve and the Bank of Canada have started a tightening cycle. Suddenly, a fixed income portfolio with an average benchmark duration of 6.5-7 years, should give investors and portfolio managers a reason to worry.

Another issue with bond indices—and thereby the passive ETFs that track them—is that the weight of individual securities in fixed income indexes is often determined by the volume of debt issued. This means that companies that issue more debt will have a higher weight in the index and therefore the passive ETFs that track them. As my colleague Patrick O’Connor stated in his interview, just because those companies make up more of the index “doesn’t necessarily mean they’re the best companies”.

The issue isn’t limited to corporate debt, it also applies to passive fixed income ETFs that track government bond indices. Just because a country issues a lot of debt, it doesn’t necessarily mean that their bonds are superior. For example, looking at data from the Citi World Government Bond Index (WGBI), we find the same problem.

So what is an investor to do? Do they now have to be an active decision maker within the passive fixed income model? To manage duration effectively you need a portfolio manager with expertise in the fixed income space that has the time and knowledge to do research and make calls on the yield curve.

One thing that I consistently hear from the advisory community is that fixed income is not one of their key strengths. Many of them enjoy following markets, researching sectors and picking funds; not managing fixed income exposure. That’s why I am often asked about active fixed income solutions. In my experience many advisors are looking for someone to whom they can outsource these efforts. And I am always happy to tell them I can help.

At Franklin Templeton Investments we have a history of managing fixed income portfolios, as we currently manage over $290b in fixed income. We also currently have 4 active fixed income ETF offerings to choose from. If you are interested in any of our active fixed income offerings, see our LibertyShares website.

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Ahmed Farooq’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.