Actively Managed ETFs Play to Market Extremes
(Bloomberg Opinion) -- By now, most finance professionals are familiar with the name Cathie Wood. Before Reddit’s WallStreetBets forum captivated traders by driving up shares of GameStop Inc., Express Inc. and other heavily shorted stocks, Wood, the head of Ark Investment Management, looked to be the clear story of 2021 with her suite of actively managed exchange-traded funds. As Eric Balchunas, an ETF analyst for Bloomberg Intelligence, told Bloomberg Businessweek: “Cathie has completely revitalized the rock star portfolio manager, which we thought was a dead concept.”
In the bond market, there’s virtually no way to compete with Wood’s Ark Innovation ETF (ticker: ARKK), which invests in companies with potentially explosive growth potential. Credit spreads, even on the riskiest junk debt, are near the lowest levels on record. Benchmark Treasury yields have increased enough in the first month of the year that total returns on investment-grade corporate bonds are firmly negative. Even convertible bonds, which rallied 50% in 2020 and have higher upside potential than traditional fixed-income offerings, still don’t come close to ARKK’s recent dominance.
Instead, it looks as if enterprising bond investors are pivoting to the other extreme, away from Reddit and ARKK.
Amid the frenetic market swings of last week, Vanguard Group Inc. announced plans to launch its first actively managed ETF since 2018. No, it’s not bringing its $7.1 trillion of assets into a competition with Wood. Instead, it’s joining several other investors in offering a nonindexed option for high-quality fixed-income securities with little interest-rate risk.
As Bloomberg News’s Katherine Greifeld and Claire Ballentine reported, Vanguard is hoping that an expense ratio of 0.1%, about half the cost of its competitors, will help the Vanguard Ultra-Short Bond ETF quickly take flight when it begins trading next quarter. That seems like a smart bet: The $15.9 billion JPMorgan Ultra-Short Income ETF (ticker: JPST) has taken in $5.27 billion over the past year, more than any other active bond ETF and among the top 10 of all fixed-income ETFs, according to data compiled by Bloomberg. It has an expense ratio of 0.18%. The Janus Henderson Short Duration Income ETF (ticker: VNLA) has brought in some $1.8 billion over the past year, more than doubling the fund’s overall size. Its expense ratio is 0.26%.
At first glance, it might be surprising that these super-short duration ETFs have attracted so much cash. JPST’s 12-month yield is just 1.43%, while VNLA’s is 1.21%. But the biggest alternatives are considerably worse. The iShares Short Treasury Bond ETF (ticker: SHV), which buys Treasuries maturing in a year or less, yielded 0.74%. The slightly longer iShares 1-3 Year Treasury Bond ETF (ticker: SHY) yielded 0.94%. Both charge a 0.15% expense ratio. And those rates are only likely to dwindle further: The U.S. Treasury auctioned $60 billion of two-year notes on Monday to yield 0.125%, a record low.
Even Vanguard’s Short-Term Corporate Bond ETF (ticker: VCSH), which has a comparatively lofty 12-month yield of 2.27%, and Short-Term Bond ETF (ticker: BSV), with a 1.79% yield, don’t quite scratch the itch of an investor looking for a better alternative to cash when yields are near record lows. The two are down 0.14% and 0.13% so far this year, respectively, while JPST is up 0.04%. That’s because the two Vanguard funds have an average duration of 2.7 years, compared with 0.72 years for JPST. As I wrote earlier this month, the yield-to-duration ratio in corporate bonds is near record lows, creating a daunting risk-reward scenario for investors.
Nick Maroutsos, head of global bonds at Janus Henderson Investors, put his pitch for VNLA like this: “You’re not going to make a ton of return, but you’ll get some income that won’t be subject to a lot of volatility. You set yourself up for an OK return for the next 12 months, and if you want to be more aggressive, you do it in the equity space.” Indeed, over any recent time horizon, an 80/20 or even 50/50 split between ARKK and an ultra-short ETF has crushed the performance of the S&P 500 Index.
It’s unlikely that managers of ultra-short income funds will ever match Wood’s star power, of course. But given that active ETFs are still a somewhat unproven option for investors, any sign that they can consistently add value is helpful. At Vanguard, it’s something of a sore subject that the investing behemoth is primarily associated with indexing. John Hollyer, head of fixed income at Vanguard Group Inc., told me in an interview last month that the company has run active bond funds for more than three decades and that his group now oversees more than $500 billion.
“We have a whole variety of expert teams, and we’re seeking to add value from numerous sources so that we’re not relying on any one source, and we’re taking lower exposure to macro bets like the direction of interest rates and more on relative value and repeatable and reliable return strategies,” Hollyer said. “That’s beneficially reinforced by our more modest fees. Meaning that we can be patient to take risk down when the risk-reward forward-looking view is not attractive. We can ramp it up when it is more attractive. We feel like that differentiates us from higher-fee competitors.”
According to the ETF prospectus, it can invest in U.S. government and agency debt, cash equivalents, corporate bonds, asset-backed and mortgage-backed securities, dollar bonds from foreign governments and companies, foreign currency bonds hedged back into dollars and even preferred stocks and certain derivatives. Vanguard already has an ultra-short-term mutual fund, which has an average duration of one year and has more than 50% of assets in the debt of financial and industrial companies, with ratings concentrated at the lower end of investment grade. When combining its 12-month yield of 1.52% with the pending ETF’s expense ratio of just 0.1%, Vanguard’s new offering clearly stands to be a formidable competitor as a cash alternative.
It might seem like a low bar for actively managed bond ETFs to just squeeze out more basis points of income than money-market funds or high-yield savings accounts. But it’s a small way to shake up the notion that ETFs and index investing need to be one and the same. They’re picking up pennies without the risk of a steamroller. They’ll leave it to Wood’s Ark Innovation ETF to shoot for the stars.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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