Examining Active Bond ETFs' Potential
Considerations to make when assessing actively managed bond ETFs relative to their mutual fund share class compatriots.
|A version of this article previously appeared in the April 2021 issue of Morningstar ETFInvestor. Click here to download a complimentary copy.|
Actively managed bond exchange-traded funds boast the same benefits over actively managed bond mutual funds that their stock-picking counterparts do. In most cases, assuming all else equal, their lower fees and the prospect for greater tax efficiency make consuming these actively managed bond portfolios in an ETF wrapper more desirable. But, at the risk of stating the obvious, bonds are not stocks. And the differences between them mean that bond ETFs often aren’t as tax-efficient as stock ETFs. Also, some actively managed bond ETFs may experience growing pains. They might not be able to faithfully replicate the portfolio of their mutual fund predecessors from day one, and they might not be more tax-efficient--at least not at first. Here, I will review these considerations in more detail through the lens of three Morningstar Medalist fixed-income funds that are available in both a mutual fund and an ETF wrapper.
Bonds are traded primarily over the counter, rather than on an exchange. Each entity that issues bonds typically has a multitude of bonds outstanding. These bond market basics are important when considering an ETF. The myriad issuers and issues mean the bond market is larger, less uniform, and less liquid than the stock market.
So, while ETF shareholders are generally insulated from the activity of other shareholders, creating baskets of bonds is complicated. It isn’t as easy to simply “in-kind” away bonds with the lowest cost basis as it might be in the case of a stock ETF.
Additionally, actively managed bond ETFs’ portfolios are typically constructed to match the key risk factors of their mutual fund predecessors’ (assuming they have one) portfolios. These include credit quality and interest-rate risk. Until they reach scale, these younger ETF siblings won’t be able to match their elders’ portfolios on a bond-by-bond basis and will often look much different until they do.
But recent developments have made life easier for portfolio managers of active bond ETFs. Actively managed bond ETFs got the green light to use custom baskets from the SEC in September 2019, when it issued the ETF Rule. This gave the funds’ portfolio managers the ability to pick and choose which bonds to put in the baskets they deliver to authorized participants to meet redemption requests. Having this latitude will go a long way toward helping managers improve the tax efficiency of active bond ETFs and further bolster their appeal relative to active bond mutual funds.
The benefits and drawbacks of investing in an actively managed bond portfolio in an ETF wrapper become clearer when illustrated with some examples. Let’s now take a look at a trio of medalist active bond ETFs that look to mimic their mutual fund parents.
HTRB launched in September 2017, aiming to replicate the success of Hartford Total Return Bond (HIABX), which debuted in July 1996. And it has done just that. The mutual fund’s less expensive share classes and the ETF earn a Morningstar Analyst Rating of Bronze, while the more expensive mutual fund share classes are rated Neutral.
The ETF and mutual fund share classes are managed by the same veteran managers with the same broad mandate, incorporating a mix of investment-grade corporates, Treasuries, and agency mortgages, with stakes in high-yield bonds, foreign bonds, and currencies.
Senior analyst Elizabeth Foos details the team’s process:
“Joseph Marvan, Campe Goodman, and Robert Burn took the reins of the strategy in 2012. The trio makes sector allocation, duration, and yield-curve decisions, while sector specialists, who are also seasoned portfolio managers, weigh in on individual security selections. The team also relies on the firm’s large analyst team, comprehensive fixed-income risk systems, and quantitative research team to hone the portfolio.
“The team has kept moderate allocations in higher-yielding sectors and has tactically increased exposure to lower-quality credits. But the strategy’s flexibility to take risk in out-of-benchmark positions means it may underperform in rocky credit markets but do relatively well when credit rallies.“
For example, the ETF’s market price fell 8.14% during the coronavirus-driven sell-off between Feb. 19 and March 23, 2020, lagging the intermediate core-plus bond Morningstar Category average by 1.36 percentage points. The mutual fund’s Retail share class fell by just 6.36%. The mutual fund held up better than the ETF in part because the ETF traded at a significant discount to its net asset value during this span. Its market price return lagged its NAV return by 60 basis points. The periodic discounts that appeared during this episode represented a relative value to the mutual fund for any investors who might have purchased the ETF at a discount. Investors who sold the ETF during this period were short-changed relative to those who liquidated their mutual fund shares. This underscores the importance of understanding and navigating ETFs’ premiums and discounts, which can flare in periods of market volatility.
From its September 2017 inception through April 2021, the ETF has outpaced the Retail share class of the mutual fund by 32 basis points annually. Much of this outperformance can be attributed to the fact that the ETF’s expense ratio is 42 basis points lower.
Interestingly, the ETF has not been more tax-efficient than its mutual fund predecessor. It distributed capital gains amounting to roughly 1% of its NAV in 2019 and 2020. Meanwhile, the Retail share class of the mutual fund made just a small capital gains distribution in 2020. According to Hartford, because the ETF is relatively new, it did not have a well of capital loss carryforwards to draw from to offset gains, while its mutual fund predecessor did.
FBND launched in October 2014, endeavoring to replicate the success of its mutual fund predecessor, Fidelity Total Bond (FTBFX), which incepted in October 2002. To date, FBND has succeeded in that regard.
The strategy’s less expensive mutual fund share classes and the ETF are rated Gold, while its more expensive mutual fund share classes are rated Silver.
The strategy is helmed by Ford O’Neil, a veteran with nearly three decades of experience who has led the strategy since 2004. Here is our team’s take on O’Neil’s charge:
“He orchestrates a team of comanagers, including Jeff Moore, another long-tenured Fidelity contributor with whom he shares a seat on the core bond desk, and Celso Munoz, a late-2017 addition to the roster who once covered insurance companies as an analyst. Michael Foggin provides guidance on non-U.S. exposures, while Michael Weaver, an early-2018 introduction to the lineup, leads the high-yield component.
“The strategy’s foundation consists of U.S. Treasuries, investment-grade corporate credit, and agency mortgages, but the allocation to each of these sectors varies depending upon the team’s assessment of relative valuations across a broad opportunity set that also includes high-yield credit, REITs, and emerging-markets debt. The strategy can hold up to 20% in below investment-grade fare, but unlike its mutual fund sibling, the ETF’s higher liquidity standard means that it avoids securities that might complicate that profile, such as high-yield commercial mortgage-backed securities, collateralized mortgage obligations, or collateralized loan obligations. Those limits haven’t dampened returns too much; as credit rallied in 2016, it held healthy allocations to most of the plus sectors, which boosted returns relative to peers that year.”
From its inception through April 2021, FBND gained 4.55% annually, outpacing the Retail share class of its predecessor mutual fund (FTBFX) by 5 basis points annually. This can be largely attributed to the ETF’s fee advantage. FBND’s annual fee is 9 basis points lower than the FTBX share class. That said, its after-tax performance has lagged, largely because FBND made a significant taxable capital gains distribution in 2020.
GTO launched in February 2016. Following Invesco’s April 2018 acquisition of Guggenheim, it has strived to replicate the success of Invesco Core Plus Bond (ACPSX). It has been mostly successful in that regard, although the ETF still lacks the requisite scale for its portfolio to more closely match the elder mutual fund. The strategy’s cheaper mutual fund share classes and the ETF earn Bronze ratings, while the more expensive mutual fund share classes are rated Neutral. Here’s our team’s take:
“Managers Matt Brill and Michael Hyman have led this strategy since July 2013. Brill oversees the strategy’s day-to-day operations and works alongside experienced comanagers and analysts specializing in corporate credit and structured products. They typically invest 40%-65% of assets in corporate bonds, 10%-20% in both agency and nonagency MBS, 10%-20% in U.S. Treasuries, and mid- to high-single-digit stakes each in commercial MBS and ABS.”
From its inception through April 2021, GTO gained 6.12% annually, outpacing the Retail share class of the mutual fund (ACPSX) by 1.26 percentage points per year. GTO has a fee advantage of 26 basis points over the Retail share class. Clearly, the ETF’s outperformance stems from more than just its expense edge.
As of May 2021, GTO held 37% of its assets in corporate bonds, 35% in government bonds, and 24% in securitized bonds. Meanwhile, the mutual fund held 45% of its assets in corporate bonds, 12% in government bonds, and 14% in securitized bonds. So, while both GTO and the mutual fund target the same key risk metrics, GTO’s heavy bend toward government-issued debt has caused its performance to deviate from the mutual fund. For instance, during the coronavirus-driven sell-off, the ETF fell 7.51% while the mutual fund dropped 8.88%.
As of May 2021, GTO had $645 million in assets under management while the mutual fund had $1.5 billion. Given its relatively smaller scale, GTO has not been able to construct the same portfolio on a bond-by-bond basis as its parent. Until it achieves sufficient scale, it is likely the funds’ performance will continue to deviate significantly. Moreover, GTO has not delivered on the tax-efficiency front. The ETF has made significant taxable capital gains distributions in each of the past three years, while its mutual fund predecessor has been relatively tax-efficient.
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Neal Kosciulek does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.