The rise of actively-managed
bond ETFs

September 10, 2019

The fixed-income sector had a tough year in 2018. But it has since recovered, and fixed-income ETFs have seen a major turnaround so far in 2019 as many funds are posting positive performance numbers. After a rough end to 2018, economists had suggested cash would outperform during 2019. That prediction didn’t quite pan out and is a perfect example of the overshoot hypothesis during market downturns. So let’s look at four fixed-income categories and see how the offerings from one the industry leaders measure up.

I spoke with Ahmed Farooq, Vice President of ETF Business Development at Franklin Templeton Investments, who told me that fixed income is the biggest area of growth for advisors as more investors are looking for cost-effective, actively-managed fixed income ETFs. Franklin Templeton has been particularly active in the ETF space and has in fact grown to be the ninth-largest ETF provider in Canada, owing mainly to strong performance among its funds combined with its cutting-edge fee structure, which I believe the entire sector will eventually emulate.

Chart 1 illustrates the average performance and MERs of four fixed-income categories, compared with Franklin Templeton ETFs, as of July 31, 2019. Franklin Templeton has outperformed the peer group average in three of the four categories and charges lower fees on average for better-performing actively-managed portfolios.

Here’s a closer look at the four Franklin Templeton ETFs, along with Ahmed’s take on what has enabled them to outperform in this volatile market.

Franklin Liberty Global Aggregate Bond ETF CAD-Hedged (TSX: FLGA)

“FLGA is currently a top-rated ETF,” says Ahmed, “We are a benchmark-aware portfolio looking to generate alpha by searching for opportunities from areas where we can reduce benchmark weight to economies that are weaker, like Japan, Germany, and France and look more to offset into other areas of Asia, Europe, and EM [emerging markets].” Ahmed adds that the key to the fund’s performance was a strategy of going longer on duration – a strategy most managers may have overlooked – while getting the asset mix correct.

Franklin Liberty Canadian Investment Grade Corporate ETF (TSX: FLCI)

Ahmed says that this ETF is a “price disruptor” in the Canadian corporate bond space. And its 35 basis point (bps) management fee is 5 bps lower than its passively managed competitor iShares Canadian Corporate Bond Index ETF (TSX: XCB). Ahmed adds, “This ETF takes a subset of an investment-grade portfolio from our parent fund, Franklin Bissett Core Plus Bond Fund, and we increased duration from 5.5 years to about 7 years. The fund buys roughly 125-150 of 976 bonds in the index, at an average A- credit rating.”

Franklin Liberty Senior Loan ETF CAD-Hedged (TSX: FLSL)

The senior loan category is untapped according to Ahmed. “We target higher-quality BB bonds, as discretionary advisors can only place so much in the high yield bucket,” he says. The managers do intensive research on holdings before committing them to the portfolio, and Ahmed says, “We do individual due diligence on the bank loans, target a 5% coupon, and 30-day duration.” He adds, “This fund is perfect if you want to hold a 2.5%-5% allocation, if you have the inability to step up to high yield, and want to keep duration ultra-short.”

Franklin Liberty U.S. Investment Grade Corporate ETF CAD-Hedged (TSX: FLUI)

Ahmed believes that most fixed-income portfolio managers were very skeptical about extending duration, adding that there’s been an apparent lack of independence at the U.S. Federal Reserve Board along with uncertainty about how U.S. President Donald Trump’s continued efforts to cut rates would be met. Of this fund, Ahmed says, “At this point, our portfolio managers started to increase duration in the U.S. investment-grade space, and by keeping a higher conviction 80-bond-holding portfolio, helped beat the average in the Global Corporate Fixed Income category by more than 300 bps.”

Chart 2 shows fund companies’ market-share percentage of the 20 top-performing fixed-income ETFs. As you can see, Franklin Templeton seems to be taking some of the bigger players head on, having entered the space as a price disruptor and having earned their keep with great performance.

There is no doubt that fixed-income ETFs are gaining attention with advisors and retail investors alike. The space is covered mostly by passively-managed fixed income funds, which are typically flagship benchmarks.

Many advisors also spend valuable time and resources managing an in-house portfolio of bonds themselves. While this may help achieve alpha sometimes, it may not be the best use of time. Investors in a volatile market usually opt for actively-managed funds because they are perceived to have some sort of downside protection in highly volatile markets.

Cost is the biggest factor in selecting actively-managed fixed-income ETFs, and with MERs at around 40 basis points, advisors are much more willing to outsource the management of the fixed-income portion of their portfolios.

Low cost combined with great performance has led to growing demand for actively-managed fixed income products, a demand that ETF providers like Franklin Templeton Investments and others are seeking to fill. It’s a sector well worth watching over the next few years to assess whether managers can fulfill the early promise of these funds.

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