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Fixed income has long been as prime territory in which active managers can strut their stuff. After all, some corners of the bond market are illiquid (emerging markets, munis, senior loans), making them more conducive to active management than indexing.
Add to that, the combination of active management and exchange traded funds has breathed new life into active management and a lot of that has to do with success on the fixed income front. There’s more good news for fans of actively managed funds. Data indicate that from July 2023 through June 2024, actively managed funds of all stripes beat their passive rivals, albeit by a modest margin. Bond ETFs are big reasons why that advantage was accrued.
Yes, there have been notable benefits in the active/ETF combination for advisors, clients and, of course, issuers. However, actively managed bond ETFs aren’t perfect. No security is, but with more and more eyeballs drifting to active fixed income ETFs, advisors should examine the drawbacks of these funds. Those include the propensity of active bond ETFs to trade at premiums or discounts to their net asset values more frequently than passively managed equivalents.
Chart Courtesy: Morningstar
Investigating Premium/Discount Issues
Interestingly, one ETFs’ primary advantages can work against active bond ETFs. That being the creation/redemption process. That takes place in the primary market between ETF issuers and authorized participants (APs) and it’s APs that source liquidity for an ETF’s underlying holdings.
The process is straight-forward and is a major reason why most ETFs are far more tax-efficient than active mutual funds, but there are times instance where even an army of APs can’t prevent an active bond ETF from trading at a premium or discount to its net asset value.
“A more important part of the equation is the liquidity of the underlying securities. Many large fund sponsors enlist scores of APs for their ETFs, yet some of their ETFs still carry a hefty premium/discount,” notes Morningstar’s Lan Anh Tran. “While the premium/discount might look profitable for APs on paper, it may be difficult to trade the underlying bonds at a price close to NAV. While ETFs have acted as price discovery signals for the underlying securities in extreme markets, it’s worth paying attention to the premium/discount you might be paying during normal times.”
Money, Time Matter
Bonds or equities, size matters in the ultra-competitive world of ETFs. Put simply, the larger an actively managed bond ETF is, the less likely it is to trade at a premium or discount to its net asset value. As Morningstar notes, the 103 actively managed ETFs with $50 million or less in assets under management traded at an average monthly premium or discount to net asset value of 0.15% for the year ending June 2024. For active ETFs with $1 billion to $5 billion in assets, that P/D percentage was 0.10%.
When money is an issue, time often is as well and that’s true with active bond ETFs. The longer the issuer can keep the fund alive, the potential for scale increases and that can help in reducing the premium/discount situation. Fortunately, none of the above is an indictment of active bond ETFs. Rather, it’s a call for advisors to monitor some of the issues that are relevant to this fund structure.
“Nonetheless, there are still many things to like about the ETF wrapper for a fixed-income fund. The availability of a secondary trading market alleviates much of the cash flow stress on the portfolio managers compared with a mutual fund,” concludes Tran. “And with time, active fixed-income managers new to ETFs should be able to develop their ETF arsenal and erase some of these small operational hiccups.”
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