Prudent Active ETF Strategies That Can Adapt to Changing Environments

As the U.S. nears a turning point in a three-decade long rally in the fixed-income market that pushed yields to record lows, bond investors may consider actively managed exchange traded funds that can better navigate changing conditions ahead.

On the recent webcast, ETF Active Management: How You Can be a Part of its Success, Dave Mazza, Head of ETF & Mutual Fund Research at State Street Global Advisors, outlined the potential drawbacks of investing in a broad bond market index strategy today.

Mazza argued that given the monthly coupon and price return, the benchmark Barclays US Aggregate Bond Index has little room to return more than its yield to maturity of 1.9%. Moreover, with a low yield, the potential for income generation from a ore allocation to the benchmark bond index is equally as low.

“The yield on the Barclays US Aggregate Bond Index is 60% below its long-term average,” Mazza said.

Meanwhile, investors are exposed to greater risks. Mazza pointed out that as yield has fallen, the Barclays US Aggregate Bond Index’s duration has increased – duration is a measure of a bond portfolio’s sensitivity to changes in interest rates, so a higher duration corresponds with greater rate risks. Specifically, the benchmark index includes about an 80% allocation toward rate sensitive sectors, including Treasuries, government-related debt and securitized debt.

David Haviland, Portfolio Manager and Managing Partner of Beaumont Capital Management, warned of the damaging effects of rising interest rates on fixed-income assets. For instance, looking at maximum drawdowns between 1973 through 2015, Haviland found that high-yield and convertible bonds have been among the worst performers during bearish conditions while U.S. 10-year bonds and foreign 10-year bonds held up better, or at least have not done as poorly.

Consequently, bond investors who still want to hold onto fixed-income assets in a rising interest rate environment ahead may consider actively managed strategies that are able to quickly modify holdings to adjust to a changing environment.

“Actively management helps managers proficiently managed risk,” Marc Pfeffer, Senior Portfolio Manager at CLS Investments, said. “The unconstrained ability to reduce or terminate exposure to asset classes with heightened levels of risk and allocate to more favorable asset classes better benefits the investor over time.”

For example, the SPDR DoubleLine Total Return Tactical ETF (NYSEArca: TOTL) has been a popular active bond play for ETF investors. TOTL is an actively managed ETF backed by bond guru Jeff Gundlach and is also seen as an ETF adaptation of the flagship DoubleLine Total Return Fund (DLTNX).

“With TOTL, investors may rely on DoubleLine Capital’s experience to help navigate an uncertain macro environment by allocating across multiple bond subsectors and applying individual security selection to potentially provide income, stability, and diversification for the core fixed income allocation,” Mazza said.

Specifically, TOTL provides a higher yield and lower duration than the benchmark Barclays U.S. Aggregate Bond Index, with a smaller standard deviation. Additionally, the active ETF has a greatly diminished exposure to U.S. Treasuries while overweighting agency MBS, non-agency debt, emerging market bonds, bank loans and high-yield, among others.

SEE MORE: Emerging Market Bond ETFs Attract Record Inflows

Similarly, investors seeking yields in a rising rate environment may consider the actively managed SPDR Blackstone/GSO Senior Loan ETF (NYSEArca: SRLN), which provide investors with better exposure to the senior floating rate bank loan market as a manager is more freely able to pick and choose the best securities. Blackstone/GSO, the subadvisor of SRLN, is one of the largest senior loan asset managers in the world.

SEE MORE: Revisiting Bank Loan ETFs for Income

“Through rigorous credit selection, SRLN has been able to avoid weak or failing senior loans that may have been included in a passive strategy, resulting in reduced volatility and better risk adjusted performance, as measured by Sharpe Ratio,” Mazza added.

Financial advisors who are interested in learning more about actively managed ETFs can watch the webcast here on demand.

This article was provided by our partners at ETFTrends.