How Active Bond ETFs Can Win Big With Smart Duration Strategies

And we’re talking about those investors who focus on duration.

It turns out that active managers who engage in duration management outperform those who don’t. This is significant information for investors. With the ever-growing number of active ETFs focusing on the bonds, separating the wheat from the chafe is increasingly important.

When it comes to fixed-income investing, passive investments tend to fall flat. This has to do with a myriad of factors. The bulk of them have to do with how indexes are constructed.

For starters, many bond indexes, such as the Bloomberg U.S. Aggregate Index, focus on liquidity. This means that bonds with the largest debt outstanding get placed in the index. In the case of many U.S. bond indexes, that means U.S. government debt. This skews bond indexes to the point that they are not representative of the actual bond universe. Moreover, it leaves out plenty of other IOUs across the board.

For active managers, this can provide opportunities. By going against the grain, moving into these other opportunities, buying bonds outside the index, and underweighting U.S. Treasury debt, they can outperform the static benchmarks.

The proof is in the pudding. A recent study by Morgan Stanley Investment Management (MSIM) found that active managers in the bond and fixed-income space have managed to crush their passive peers in 84 different rolling three-, five- and 10-year periods. That outperformance was as high as 121 basis points per year in some bond categories. Other academic studies have produced similar results, with active bond managers outperforming their passive peers.

Digging deeper, there are two ways that active bond managers can boost returns — credit and duration management.

Credit is what we think of when it comes to active bond management. It’s pouring over a firm’s fundamentals and its ability to repay the debt, looking at cash flows, running default risk scenarios, and checking assets to cover the bond and the bond’s price vs. yield.

The other way is duration management. Duration is a measurement of a bond’s interest rate risk that also considers factors like a bond’s maturity, yield, coupon, and call features. Duration can be used to figure out how much a bond will fall when rates rise, and vice-versa.

For example, if the Fed raises rates by 1%, a bond with a 5-year average duration would see its price drop by 5%. A bond with a 30-year duration would see a 30% price decline, which helps explain why the Bloomberg US Aggregate Bond Index lost nearly 13% back in 2023 — the worst return for bonds in over 250 years.

It turns out that duration management might be more important than focusing on credit when it comes to returns and outperformance.

According to a new whitepaper from fixed-income manager Lord Abbett, managers who focus on duration timing may have an edge over those who don’t focus on it at all. When looking at the return profiles of active managers in the core bond category and dividing them into duration profiles of longer than one year (duration timers) and those with positions less than one year, Lord Abbett found a significant positive skew towards investors who are duration timers. This excess performance can be as much as 25 bps per month or about 3% in excess return annually dating to 2005. This table sums up some of their findings. ¹

The key to the study is that this duration management of those investors who get it right, really get it right, and those that don’t — the bottom 25

The problem is that investors have no idea which manager is skilled at doing this. Even superstar managers can fall to poor duration management or get the trends wrong. While Lord Abbett’s study doesn’t name names, it does highlight the “recent experience of several high-profile managers” in poor duration bets.

So, how do investors use this data, particularly when it comes to active ETFs in the bond sector? The short answer is that investors may want to look carefully at a fund’s underlying duration. And they do vary across active bond ETFs. All good fund companies will report such information on the fund’s profile page. For example, the SPDR DoubleLine Total Return Tactical ETF has a duration of 6.16 years, while the Fidelity Total Bond ETF has a duration of 5.98 years.

In a rising rate environment, managers with lower durations or those who have been cutting duration from their portfolios should outperform the others. In a falling environment, like today, those who are adding duration should win. The issue is, how well they can judge the turn and change in Fed policy ahead of time.

This might prove difficult to nail down. The answer may be to focus on active bond ETFs with shorter mandates or to own several ETFs to cover your basis.

These ETFs were selected based on their low-cost exposure to active bond management. They are sorted by their YTD total return, which ranges from -2.8% to 2.8%. They have expenses between 0.18% and 0.70% and assets between $3B and $23B. They are currently yielding between 4.4% and 9%.

Either way, duration management is key to active bond manager outperformance and excess returns. Those who do it right can significantly boost returns for their investors and bond portfolios. The trick is finding out who has the skill to time the Fed policy correctly.

Active managers in the bond space have long been able to outperform their passive benchmarks and indexes. Duration management seems to be a key component of that outperformance. For investors, looking at duration could be a great way to find managers with the skills to outperform other active managers and benchmarks.

¹ Lord Abbett (August 2024). Active Management in Fixed Income: Two Approaches with Different Results