The case for active management with ETFs

Nov 9th, 2020 | By | Category: Fixed Income

By Ryan Blute, PIMCO, Head of EMEA Global Wealth Management.

The case for active management with ETFs

Ryan Blute, PIMCO, Head of EMEA Global Wealth Management.

ETFs have been growing quickly in Europe in recent years, albeit from a small base relative to traditional mutual funds.  But if the U.S. market can serve as a guide, there is likely to be continued strong growth in the years ahead. Amidst this growth, there is also likely to be investment product innovation, ranging from new benchmarks to new asset classes for both institutional and individual investors.  Yet one misconception continues to plague the ETF investment vehicle – namely, that ETFs equal passive investments.

ETFs should be viewed merely as investment “vehicles” which provide access to investments in a structure that comes with certain features and benefits.  When choosing an investment, the single most important decision is what the investment strategy should be, such as European corporate bonds, Emerging Market Local bonds, etc… The follow-up decision should then be the investment vehicle, such as ETF, traditional mutual fund, or segregated account.  Yet while many investors have historically used ETF vehicles as a way to access passive investment strategies, PIMCO believes that these investors may be losing out on opportunities to enhance their returns through active management while also benefitting from the structure of the ETF vehicle.

Investors choose the ETF vehicle for a variety of reasons, ranging from its intraday trading liquidity to the transparency provided through holdings disclosure, to the potential for lower fees relative to traditional retail share classes of mutual funds.  But while passive investment strategies have historically dominated the ETF marketplace, active management is gaining ground.

PIMCO was a pioneer in active management of fixed income dating back to the 1970s and has equally been a pioneer in active management of fixed income ETFs, dating back almost ten years.  And we expect investors to continue to migrate towards active fixed income ETFs in an environment of persistently low interest rates.

Active management in fixed income can take advantage of a number of inefficiencies in the bond market which introduce opportunities to enhance returns without increasing risk. And these can all be applied to the ETF vehicle.  Firstly, the bond market continues to be influenced by the rating agencies, which set bond ratings that must be followed by passive index followers, regulated banks and insurance companies, and many institutional pension plans.  These investors may follow rote rules which require adjustments to their portfolios when bonds are downgraded, introducing an opportunity for independent, value-oriented investors to buy these securities at attractive prices.  Secondly, many official institutions such as central banks purchase fixed income securities with an objective other than maximizing total return.  This also introduces distortions in that certain securities persistently “trade rich” meaning that those who passively follow an index must overpay for these bonds held by somewhat “non-economic actors”. Active managers of ETFs can take the opposite view and purchase similar bonds at more attractive yields. Thirdly – and related – certain investors like insurance companies use bonds for their income features and are subject to specific accounting regulations that distort their transactions in certain securities to optimize financial statement results.  Active managers can also take advantage of these “clientele effects” and avoid these bonds which are consistently overpriced.  And finally, active ETF managers can take advantage of passive ETF managers who are forced to buy securities that track an index.  A perfect example is in the case of corporate bonds, in which passive ETFs must buy the largest or most liquid bond of issuers in the index they seek to track.  Active managers are keenly aware of these bonds and can avoid them and substitute more attractively priced, and substantially similar, alternatives.  Then, when these passive ETFs suffer from outflows, active managers can take advantage of the fact that the prices of these “must-own” securities fall in price beyond fundamentals and buy them at more attractive yields.

While active investing is the most attractive way to invest in many areas of the fixed income market, there are some areas that can offer attractive embedded returns. In those instances we may look to capture those in the most efficient and intelligent way we can – whether you call it “smart” passive or better beta.

For example, high yield bonds with maturities shorter than five years may have advantages over those with longer maturities – they have less spread duration and so tend to be relatively defensive in an equity downturn. They have also historically provided returns on par with equities but at about half the volatility. And choosing an index with a 0-5 year maturity range rather than 1-5 allows us to hold bonds to maturity, avoiding selling at year one and the accompanying costly transaction costs. When we think about “smart” passive indexing, we are not as focused on minimizing short-term tracking error as we are on other objectives, such as liquidity, transaction costs and portfolio turnover.

Whether investors are looking for active or passive strategies in fixed income ETFs, our full spectrum of strategies are leveraging the resources, investment process and expertise of the entire PIMCO team. At the end of the day, we are seeking to deliver a suite of ETFs that enable investors to meet their specific risk and return goals across the fixed income opportunity set, marrying PIMCO’s fixed income expertise to the ease and efficiency of the ETF vehicle.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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