Fixing fixed income - Are passive fixed income ETFs broken?

Ahmed Farooq, CIMA®, CFP

Ahmed Farooq, CIMA®, CFP
Vice President - ETF Business Development at Franklin Templeton Canada

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Last month I went to Montreal with some of my colleagues to take part in the inaugural Canadian Inside ETFs conference. I truly enjoyed the event and there was a lot of great discussions 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 came to fixed income ETFs, 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. The bull market in bonds have come to an end now that the Federal Reserve and the Bank of Canada have started a tightening cycle. Suddenly, a fixed income portfolio are now giving 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 $369b 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, please feel to reach out to me directly.

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What Are the Risks?

Commissions, management fees and expenses may all be associated with investments in ETFs. Investors should carefully consider an ETF’s investment objectives and strategies, risks, fees and expenses before investing. The prospectus and ETF facts contain this and other information. Please read the prospectus and ETF facts carefully before investing. ETFs trade like stocks, fluctuate in market value and may trade at prices above or below the ETF’s net asset value. Brokerage commissions and ETF expenses will reduce returns. Performance of an ETF may vary significantly from the performance of an index, as a result of transaction costs, expenses and other factors. The indicated rates of return are the historical annual compounded total returns including changes in share or unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any security holder that would have reduced returns. ETFs are not guaranteed, their values change frequently and past performance may not be repeated.

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.

All investments involve risks, including the possible loss of principal. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.