Introduction

When it comes to fixed income exchange-traded fund (ETF) investment choices, investors have two main management strategies to consider: passive (via indexing) and active. In this article, we explore some of the differences between index and active fixed income strategies plus some of the benefits they offer investors.

Indexing approaches

In the fixed income realm, it’s important to understand the two main approaches to index investing: replication and sampling.

Key terms

• Replication: The ETF aims to replicate the performance of a chosen index, typically by holding the same securities at generally the same weights as the index.
• Sampling: The portfolio manager uses quantitative, qualitative, and statistical analysis to select certain securities held by the index to create a representative sample that resembles the index in selected characteristics, such as risk factors and performance attributes.

Replication

In this approach, an ETF aims to track the performance of an index by holding all the securities held by the index, at generally the same weights. Many equity ETFs take this approach. However, replication is less common among fixed income ETFs, for two key reasons:

1. Fixed income indexes typically include more securities than equity indexes—potentially thousands of bonds—which complicates the purchase of the full set of securities.
2. The constituents in a fixed income index may be less liquid because many investors buy bonds intending to hold them until maturity. This makes it difficult to purchase bonds, thus making it difficult to fully replicate fixed income indexes.

Sampling

Rather than using replication as a fixed income ETF approach, a portfolio manager may employ a sampling approach instead. Here the portfolio manager selects a subset of securities from the index with the goal of mimicking the characteristics, performance, risk factors, and dimensions of the fixed income index. These characteristics may include maturity, credit quality, industry sector, correlations, exposure, and credit risk.

Sampling offers a way to track an index that otherwise would be difficult to track because it contains many constituents, lower liquidity, or both. Plus, saving on trading costs and expenses may help the portfolio manager deliver the returns of the index.

However, unlike replication, sampling leaves open the possibility that returns could diverge from the index returns based on how well a portfolio manager samples the index to the portfolio.

This hypothetical example is for illustrative purposes only.

Active management

The alternative to indexing is active management. Typically, investors who choose this method do so because they want to seek greater returns than those of a respective index.

In active management of a fixed income portfolio, the portfolio manager allocates among various sectors and risk factors of the fixed income market that fluctuate over time. This is similar to active management of an equity portfolio, where the manager seeks the best performers among the overall market of stocks.

Fixed income portfolio managers can also customize portfolios by managing sector strategy, duration, interest rate expectations, and credit risk.

Sector management

Selecting among government, mortgage-backed, and corporate fixed income securities can help a portfolio manager capture gains or preserve principal in varying economic and interest rate environments. Additionally, the manager can add value by identifying which sectors to overweight and underweight given the valuations of specific bond market sectors, a strategy that is known as sector rotation.

Duration and yield curve management

Since interest rates typically don’t rise uniformly on the yield curve, an active manager has the flexibility to emphasize a certain part of the curve (short-, intermediate-, or long-term). Managing interest rate risk by choosing the weighted maturity or duration of an ETF is a key performance driver in actively managed ETFs.

Credit risk management

If a portfolio manager can accurately identify bonds that are undervalued or overvalued given their credit risk profile, the manager can seek to outperform an index by overweighting higher yielding bonds. The portfolio manager can also seek to outperform by overweighting or underweighting industries or parts of the credit quality spectrum.

Fixed Income ETFs: Comparing indexing and active management

Summary

Both index and active fixed income ETFs offer diversified ways to access the bond market. Index fixed income ETFs may provide a more cost-effective way to access individual markets because the portfolio manager doesn’t need to spend resources to assess various fixed income factors.

Active management of a fixed income ETF portfolio may help achieve gains beyond index returns or better preserve capital, depending on the interest rate environment. Often, active managers can minimize the impact of rising rates by moving away from potentially lower yielding bonds.

Each investor should review their options and determine their preference for cost and risk. Ultimately this will help them decide if an index or active fixed income ETF is right for them.