2023 saw many twists and turns in financial markets. Yet, one enduring trend was the growth of active and fixed income ETFs as measured by inflows and new ETF launches. Andres Rincon, the Head of ETF Sales and Strategy at TD Securities, shares why this was the case and what’s next for 2024.
A major factor is that mutual funds had net outflows, while ETFs had nearly an equivalent amount of inflows. This is an indication of a secular shift as investors and institutions increasingly favor ETFs due to more liquidity and transparency. In response, many asset managers are now converting fixed income mutual funds into active ETFs or offer dual versions.
Fixed income ETFs also benefited from yields being at their highest level in decades in addition to an uncertain economic outlook. Despite the rally in fixed income in the last couple of months of 2023, Rincon notes that investors had been positioning themselves for a downturn in the economy and pivot in Fed policy starting early in the year.
Flows into active fixed income ETFs have also been strong, given that fixed income is more complex than equities. This is despite these ETFs typically having higher fees. Yet, active managers are able to take advantage of inefficiencies that are unavailable to passive funds. And, active is a particularly good fit for the current moment when there is indecision about the timing and extent of the Fed’s next move.
Finsum: TD’s Andres Rincon discusses what drove the surge of inflows into fixed income and active ETFs last year. And, why these trends should continue in 2024.
PIMCO sees a changed environment in 2024 as the Fed will pivot to rate cuts. However, it sees the impact of prior rate hikes still impacting economies and leading to stagnation or a mild contraction.
Financial markets will be focusing on the timing and pace of rate cuts. Based on history, central banks don’t ease in anticipation of economic weakness. Instead, they tend to cut only after recessionary conditions materialize and tend to cut more than expected by the market.
PIMCO agrees with Chair Powell that inflation and growth risks are now more ‘symmetrical’. However, it believes the market is underpricing recession risk especially given that some assets are already priced for a soft landing given the strong rally in many assets over the past few months.
It also believes that fixed income is particularly appropriate for this environment given that yields are still close to multi-decade highs. It also offers protection and upside in the event of economic conditions deteriorating. Within the asset class, it favors mortgage-backed securities and believes investors should stick to medium-duration bonds as yields are attractive while interest rate risk is reduced. On a longer-term basis, PIMCO sees neutral policy rates to reach similar levels to before the pandemic which is also supportive of the category.
Finsum: PIMCO sees financial conditions easing in 2024 as the Fed cuts rates, but economic conditions will deteriorate given the delayed impact of tight monetary policy.
There’s a major drawback to today’s hyper-connected world where investors are constantly receiving financial advice that is mostly short-term and doesn’t necessarily have the investors’ best interests in mind. Contrast that approach to a long-term, fundamental based approach that is based on timeless principles rather than impulsive thinking.
Recently, there has been a narrative that individuals should be buying individual bonds. Adam Abbas, a portfolio manager at Oakmark Funds, pushed back against this notion and made the case for why most investors are better off with mutual funds and ETFs.
He acknowledges that bonds look very appealing given where rates are relative to historic levels and that default rates for high-quality securities are likely to remain low. However, the risk climbs when investors start ‘reaching for yield’ which tends to happen with individual investors. Therefore, some sort of comprehensive credit analysis is required from a bottom-up perspective.
Further, most individual investors will not be able to sufficiently diversify their portfolios. This means that their portfolios would be damaged by a corporate bond default. In addition to understanding companies, investors also need to have a grasp on the macro picture as factors like inflation or rate policy can also impact returns.
Given these difficulties, most investors are better off choosing an astute active manager to invest in bonds as they will conduct proper due diligence and ensure that portfolios are sufficiently diversified.
Finsum: There’s a trend of individual investors buying individual bonds. Oakmark’s Adam Abbas pushes back against this and makes the case for why most investors are better off with a mutual fund or ETF.
2023 was a year of twists and turns for fixed income, although it ended with a big rally in the final months of the year. In 2024, Schwab Fixed Income strategist Collin Martin forecasts positive returns for the asset class and believes that yields have already peaked. Additionally, he notes that bonds are once again a diversifier against equities after an ‘anomalous’ 2022, especially at current yields.
Despite believing that yields have peaked, he remains bullish on the asset class, noting attractive opportunities to generate substantial income. However, investors will need to be selective in terms of duration and quality. Martin recommends longer-duration securities to take advantage of higher yields even if yields are currently higher in CDs, bank deposits, or Treasury bills. This is because longer-term yields at 4% are quite attractive, and it negates interest rate risk in the event of Fed rate cuts.
Martin added that investors should prioritize quality especially since there is no additional compensation for taking on risk in lower-rated or high-yield debt given current spreads. Therefore, stick to Treasuries or high-quality corporate debt which offer generous yields with minimal risk. Both would also outperform in the event that economic conditions further deteriorate.
Finsum: Schwab is bullish on fixed income in 2024 although it believes that investors need to be selective in terms of quality and duration.
Separately managed accounts (SMAs) have been utilized for decades to effectively manage client assets. Benefits include transparency, flexibility, control over costs, and choice. They can be optimized for various purposes including taxes, income, cash flow, etc. They also allow for more customization than ETFs or mutual funds.
They are particularly popular for fixed income purposes and have seen impressive growth in recent years. For instance, municipal fixed-income assets went from $100 billion in 2008 to $718 billion in July 2023. In part, this is due to SMAs becoming more accessible to a wider universe of investors as improved technology has led to lower costs and lower minimum amounts to invest.
ETF’s presence in the municipal bond market is also growing fast. There are now 81 funds and $108 billion in assets, a 50% increase from 2021 but less than 3% of the total muni market. Many active mutual funds are being converted into active ETFs. One advantage is greater liquidity which allows investors to quickly gain exposure as a placeholder while they accumulate individual securities.
Mutual fund flows can be affected by market sentiment, leading to selling during periods of redemption, which is not an issue with SMAs. Due to the growth of SMAs and ETFs, muni mutual funds have seen net outflows over the last couple of years. Another factor is high rates making short-term securities or bank deposits more attractive relative to longer-duration assets.
Finsum: There are multiple ways to invest in municipal bonds. One of the fastest-growing methods is through separately managed accounts which offer some specific benefits relative to ETFs or mutual funds.
Franklin Templeton is optimistic about fixed income in the coming year due to the Federal Reserve ending its hiking cycle, and inflation continuing to trend lower. However, it believes that rates will remain at these levels for much of 2024 in order for inflation to fall to the Fed’s desired level, leading to a more challenging environment in the first-half of the year.
Amid this backdrop, the firm is bullish on municipal bonds especially with so many investors on the sidelines, overweight cash, or in short-term credit. Municipal bonds offer historically attractive yields, favorable tax treatment, and a longer-duration which should outperform in an environment with falling rates and a flattening yield curve.
The firm notes that local governments remain in strong shape from a fiscal perspective even despite a slowdown in economic activity and rising costs. Many still have excess funds leftover from federal aid during the pandemic and have been relatively disciplined in terms of spending. Further, muni bonds have lower default rates than corporate credit while also having higher after-tax returns. Franklin Templeton believes many investors will reallocate from money markets into municipal bonds in order to lock in yields at these levels especially as monetary policy eases.
Finsum: Franklin Templeton is bullish on fixed income in the coming year. It also highlights a bullish case for municipal bonds due to the sector’s strong fundamentals and favorable positioning in this macro environment.
Passive ETFs have lower expense ratios because they don't require a team of portfolio managers to constantly analyze and adjust the mix of underlying investments. Over time, this lower cost can add a meaningful amount to the value of an investor's holdings.
While advisors and investors appreciate lower expense ratios, ETF's benefits extend beyond a simple fee advantage. A closer look reveals another hidden strength: real-time trading.
Unlike traditional mutual funds, which price investments only at day's end, ETFs operate like stocks, providing continuous price transparency and allowing for immediate execution. Gone are the days of uncertainty surrounding redemption values; with ETFs, you see the precise price you'll pay and receive, empowering informed decisions throughout the trading day.
Yet another impactful advantage lies in their liquidity. Popular ETFs often boast trading volumes exceeding even blue-chip stocks. This translates to tight bid-ask spreads, minimizing the price difference between buying and selling, and enabling efficient trade execution.
The combination of low-cost, real-time pricing, and ample liquidity make ETFs powerful tools for financial advisors seeking precision and flexibility within their client's portfolios.
Finsum: Low cost is not the only reason financial advisors should consider ETFs in their client’s portfolios. Consider these other advantages as well.
Stocks whose prices trail their implied intrinsic value are often seen as attractive investments primarily due to their undervaluation. But a recent article by Vanguard suggests another reason value stocks may be worth considering now. Historically, value stocks have outperformed their “growth” counterparts in times of economic recovery.
The report quotes Kevin DiCiurcio, CFA, head of the Vanguard Capital Markets Model® research team, as he makes the case. “So, if you believe that the Federal Reserve may have engineered a soft landing—that we’re going to sidestep a recession and that the economy’s next move is an acceleration—the case for value is strengthened.”
According to their research published in August, 2023, Vanguard estimated that value stocks were priced more than 51% below their fair value prediction. They stated, “It’s well-known... that asset prices can stray meaningfully from perceived fair values for extended periods. However, as we explained in (previous research), deviations from fair value and future relative returns share an inverse and statistically significant relationship over five- and 10-year periods.”
This observation adds one more reason value stocks are worth a look. In addition to favorable valuations and historically consistent dividends, the possibility that value stocks may shine during the coming economic recovery many anticipate, is another factor to consider. Whether held directly, within a passive allocation, or as part of a Separately Managed Account, now is a perfect time to revisit the case for value stocks in your client’s portfolios.
Finsum: Vanguard's research highlights value stock historical outperformance during economic recoveries.
If you’re tinkering with the idea of bonds, consider this: the challenges on the fixed income landscape, according to money.usnews.com. For those who aren’t initiated, individual bonds – which trade over the counter – it can be a tough road to hoe.
That’s where bonds funds come in. For investors, they’re an entrée to diversified bonds. And what about the complexities of direct bond investment? There are none.
"Given the higher risks and costs associated with portfolios of individual bonds, and the time they take to manage, most investors are better served by low-cost mutual funds and exchange-traded funds, or ETFs," said Chris Tidmore, senior manager at Vanguard's Investment Advisory Research Center. "This is particularly true in the case of municipal and corporate bonds, which are less liquid and harder to purchase than Treasury bonds."
Meantime, calling it a day was Eric Needleman, global head of Fixed Income, who plans to do so by year’s end, according to an announcement by Stifel Financial Corp., reported yahoo.com.
"We are deeply grateful for Eric’s dedication, leadership, and the lasting impact he has made on our firm,” said Stifel Chairman and CEO Ron Kruszewski. “He set a standard of excellence that will continue to define Stifel's approach to the fixed income business.”
Risk adverse?
Well, perhaps you’ve pulled up to the right window. After all, a big upside of active fixed income management: risk mitigation, according to npifund-com.
Possible problems – before they damage client portfolios – can be traded out of by alert active fixed income managers. What’s more, the site states: “We believe the next problem to address with active management is the leverage bubble in corporate debt. The disproportionately large BBB market, in particular, “poses a risk to the markets in the event of a wave of downgrades under the right recessionary scenario.”
Meantime, it seems investment strategy and fixed income teams at Vanguard have been burning a little midnight oil.
According to corpaemdisp.essp.c1.vanguard.com, new research from the company’s teams taken a close look into how the growth of a diverse coupon stack in the municipal bond market, followed by, down the line, “aggressive Fed rate hikes put negative convexity front and center in active muni investing.”
Those active managers steering through this environment of souped up rates are gaining leverage. Why? Because they’ve been able to wrap their heads around how to manage negative convexity risk – and they’ve been prudent while they’re at it.
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Share and share alike?
Well, tell that to exchange traded funds. While they burgeoned in popularity, when it comes to sharing equally – or consistently – in the billions of dollars investors pluck down on them monthly, they don’t exactly participate, according to thinkadvisor.com.
An ETF focused on environmental, social and governance investing was one that trailed the pack. Year to date, it experienced the largest withdrawals. “(That suggests) that there may be some backlash against ESG from investors,” said Sumit Roy, senior ETF analyst at ETF.com.
In any event, as an investor, want a cost effective way to diversify your portfolios across various asset classes: you’ll get that from top ETFs, according to Investopedia.com. The work of ETFs, it seems, is never done. Not only does it track a particular index, sector or commodity and trade on a stock exchange, the way in which it goes about it mirrors that of a regular stock, putting investors in a position to wield greater flexibility.
Stress in the bank sector? Sure, okay.
Uncertainty spawned by the U.S debt ceiling? Yep, no one can legitimately propose an argument to the contrary.
Political uncertainly festering in Russia? Well, yeah, if you’ve watched even a scintilla of news lately.
Despite that exhaustive list, the global economy’s hanging tough, strutting its resilience, according to gsam.com, which believes a restored allocation to core fixed income can help boost the ability to reinforce the resilience off portfolios to periods of bearish sentiments. That’s especially in light of a bounce in yields which have bolstered the protective power and income benefits of high quality bonds.
Meantime, the economy continues to perform better than expected, seemingly shucking aside rates hikes that have been a mainstay since last March, according to privatewealth-insights-bmo.com.
Consumers, buoyed by high employment, not to mention escalating wages, have hung tough.
For this cycle, with Canadian rates riding high and the stream of rate hikes -- for the most part, at least -a thing of the past, the time to take another look at fixed income allocations is right.
In one corner of the investment world: the traditionalists; in the other, the alternatives.
A survey of 191 investment professionals from February 14, 2023 to April 7of this year showed a mounting interest in alternative investments among professionals, at 28%, predating the pandemic, according to thestreet.com.
"As traditional stock and bond asset classes suffered from losses and volatility in 2022, it's not surprising that interest in alternative investments increased among financial professionals. However, overall use of alternatives remains relatively low,” 2023 FPA President James Lee, CFP, CRPC, AIF, said in a press release.
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While alternative investments are catching the attention of some financial advisers, the survey highlighted that over 90 percent of investment professionals currently use or recommend exchange-traded funds (ETFs).
Unlike traditional assets, of course, alternative investments aren’t subject to US Securities and Exchange Commission regulatory requirements, according to coresignal.com. That’s significant since it translates in further room for speculative investment practices.
There’s a scant link between alternative assets and the stock market – not to mention other conventional investments, according to coresignal.com. Consequently, they’re not required to react to market conditions as they shift. For conventional securities, it’s a different story.
Alternative investments, fueled by high fees and minimums, typically are accessible to institutional investors exclusively.
It seems there’s not much, um, fixed, about fixed income. That’s because, pre tell, in the second half of the year, conditions there likely will be choppy, according to dayhagan.com.
Ongoing tightening by central banks in the developed markets is pushing up short term yields, while long term yields are feeling the weight of slower growth and a pull back in inflation seemingly on the horizon later this year.
Meantime, the fixed income allocation strategy experienced scant changes in sector allocations coming into the month.
Now, want to talk about a calorie burner? Presenting active, active and more of it.
As in, as if you had to ask, active management.
"Everywhere we turn, we are hearing that a new dawn is upon us, and it is once again the time for active management. Many would be surprised that I totally agree, said Jason Xavier, head of EMEA ETF Capital Markets at Franklin Templeton, according to global.beyondbullsandbears.com.
It could be argued – as outlined in his predictions for the year – that the decade of “cheap” money and unprecedented low interest rates are a thing of the past and that those with the chops to work the volatile markets will reap the benefits.
That said, the picture on the horizon boasts considerably more potential; in other words, the dawn of active fixed income in the exchange traded fund or ETF vehicle. Clinging to the assumption that ETFs are a passive vehicle – and passive vehicles only – is a myth, he continued.