Passive bond ETFs aim to provide representative market exposure, but inadequate market data means they may not deliver what they promise. Active ETFs could be a more effective solution.

Bond ETFs – what is the point?

The core purpose of exchange-traded funds (ETFs) is to allow any investor – whether an individual or a large institution – to implement their chosen asset allocation quickly and efficiently. In the complex world of fixed income, the arrival of bond ETFs has been welcomed, particularly by non-specialist investors like multi-asset funds and smaller institutions.

In many respects they’re a success, delivering low-cost exposure and gathering significant assets under management. However, when it comes to the most critical aspect – providing accurate and representative market exposure – passive bond ETFs often miss the mark. Investors aren’t getting the kind of exposure they think they’re getting, and the issue boils down to data.

Building a bond index is easier said than done

Creating an investable index involves two key decisions: how to select securities and how to weight them. The goal is to create a portfolio that is both representative and liquid. In equity markets, this is relatively straightforward. Trading volume data is readily available as a measure of liquidity while market capitalisation – though imperfect – provides an adequate gauge of a company’s importance in the market.

In fixed income, indexation is much more difficult. Broad benchmarks typically comprise not hundreds but thousands of securities, making efficient replication a challenge. For example, Bloomberg’s Euro Corporate Bond Index includes over 3,500 bonds. However, the real problem is how those bonds are selected and weighted. Most indices rely heavily on issue size and/or the amount outstanding because this is the data that’s readily available. Even “liquid” indices, designed to be easier to replicate, use these metrics to select the largest bond issues. But unfortunately, availability isn’t the same thing as relevance.

Using issuance size as a proxy for liquidity is deeply flawed. In reality, large institutional investors often buy bonds in the primary market and hold them to maturity. As a result, true liquidity is fragmented and can’t easily be captured by index rules. Similarly, weighting securities by the amount of outstanding debt has long been criticised. It rewards more heavily-indebted issuers, which can distort exposure. More generally, it is being used as a stand-in for market data that simply isn’t available. This makes passive replication in fixed income inherently imprecise.

The active ETF advantage

Specialist fixed income managers are aware of these limitations. Much of the imperative for active management in fixed income isn’t outperformance but accuracy.  Outperformance is a nice-to-have, but the primary challenge is to accurately reflect a market that isn’t well-defined by standard data points and where liquidity is hard to measure. Solving this problem requires extensive resources, technology and systems to generate deep market insights and the resources and technology to properly analyse and understand complex markets. Solving this problem requires sophisticated systems and visibility across and within bond markets – resources typically found in large asset managers with a significant market presence.

Collateralised Loan Obligations (CLOs): Passive limitations

Loans and CLOs now represent a growing share of global debt markets, meaning it’s increasingly important to include them in diversified portfolios. CLO indices are now available but passive ETFs haven’t sprung up to meet investor demand. In fact, all CLO ETFs are actively managed. The data, systems and due diligence needed to properly understand and compare CLOs are beyond the scope of what index and market data providers can offer. What’s more, a passive approach would tend to reflect dealer inventory (bonds that a bond dealer holds in their own account for trading purposes), with no consideration of manager concentration and other portfolio risk factors.

Raising the bar for core fixed income

The challenges of indexation don’t just affect the more esoteric corners of the bond market. Even the most basic building blocks of a fixed income portfolio could benefit from an active approach based on deep market insights.

If the goal is to reflect a market that doesn’t conform well to traditional indexing, active ETFs can provide a more accurate and effective solution.