Bond Indexes Are `Broken,' Says Franklin Templeton ETF Head

(Bloomberg) -- Fixed-income indexes are “broken,” making active management necessary for successful bond ETFs, according to the head of global exchange-traded funds at Franklin Templeton Investments.

“Investors typically have gone into passive fixed income primarily because that’s all there was,” Patrick O’Connor said Thursday in an interview on the sidelines of the Inside ETFs Canada conference in Montreal. “But as a firm, and as an active manager, we don’t just think indexes are flawed in fixed income, we think they’re broken.”

The weight of individual securities in fixed-income indexes is often determined by debt issued, meaning companies that issue more debt will have a higher weight in an index-based ETF.

“That doesn’t necessarily mean they’re the best companies, but they would be the ones that a passive manager would have to overweight,” said O’Connor, who manages Franklin Templeton’s $1.5 billion ETF platform.

Another problem facing passively managed bond ETFs is that the indexes they track often add securities when the debt is upgraded and prices rise, and remove securities when the debt is downgraded and prices fall, said Don Suskind, head of the ETF strategy team at Pacific Investment Management Co.

“So you’re a forced buyer after the price has gone up, you’re a forced seller after the price has gone down,” Suskind said, speaking on a panel at the Inside ETFs conference.

In addition, “there’s whole sections of the bond market you simply can’t access” with a passive ETF, he said, pointing to U.S. non-agency mortgage bonds as one of his preferred investments. “You’re missing out on entire portions of the bond market including what we think are some of the best investments on the planet.”

Among actively managed bond funds, 61 percent outperformed their passive peers in 2017, according to Morningstar data.

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