From the Field
Active fixed income ETFs have the potential to outperform
Key Insights
- Actively managed exchange-traded funds (ETFs) can potentially outperform benchmarks with skilled security selection and comprehensive analysis.
- T. Rowe Price uses a blend of fundamental, macro, and quantitative analyses for its active fixed income ETFs.
- Investors can access multiple T. Rowe Price fixed income ETFs with various risk profiles to meet investment goals.
Passively managed fixed income exchange-traded funds (ETFs) remain a popular choice for many investors, but they come with a number of potential challenges. Actively managed ETFs differ in several key aspects from their passive counterparts, and more investors are turning to these vehicles to address their fixed income investment needs.
What is a fixed income ETF?
Fixed income ETFs, or bond ETFs as they’re sometimes called, invest in fixed income securities (namely bonds) as opposed to equities. These fixed income ETFs enable investors to participate in the bond market without having to go through the arduous process of researching and selecting individual bonds on their own. While stock ETFs are primarily focused on long-term growth, fixed income ETFs may include an income component for investors. Additionally, bonds are a relatively conservative asset class, meaning fixed income ETFs can help investors off set the volatility associated with stocks and other investment types.
How do fixed income ETFs work?
Fixed income ETFs work similarly to other types of ETFs. The fund purchases shares of securities (in this case, bonds), and investors have the opportunity to buy shares of the fund. Unlike a mutual fund, a fixed income ETF can be traded multiple times throughout the market day. Fixed income ETFs may also be more accessible to investors than fixed income mutual funds, since mutual funds typically include investment minimums and ETFs are purchased by the share.
Types of fixed income ETFs
Fixed income ETFs can be broadly placed into two categories based on how they’re managed: active ETFs and passive ETFs. Within each category, investors can find opportunities to invest in different bond types with varying levels of risk and return potential, from emerging market bonds to corporate bonds, government bonds, and more.
The challenges of passive fixed income ETFs
1. True index replication is nearly impossible. The Bloomberg U.S. Aggregate Bond Index is a case in point. This benchmark comprises over 12,000 individual securities, some of which are very thinly traded. To replicate the bond index with each component security would be both time-consuming and prohibitively expensive largely due to wide bid/ask spreads.
2. Passive strategies often lack the flexibility to adapt to changing market environments. If there is meaningful credit deterioration in a particular industry, for example, a passive ETF may continue to hold the affected bonds. On the flip side, these fixed income products aren’t designed to increase exposure to a company or sector in the bond market that is judged to be undervalued and thus may be poised to perform well.
3. There is an absence of individual security research and analysis in passive fixed income ETFs. By simply buying a large basket of bonds, these vehicles face the potential for greater credit risk and issuer default. Bonds are included in the portfolio merely because they are in the index, not because an experienced investment professional applied fundamental research to independently evaluate their credit quality.
The T. Rowe Price fixed income difference
1. Active ETFs offer the potential to outperform fixed income benchmarks and indexes. By seeking to avoid bonds with looming credit issues and owning those with more attractive fundamentals, our actively managed ETFs seek to deliver meaningful alpha for fixed income investors—and this potential for cumulative outperformance over a benchmark can add up over time.
2. Careful security selection may offer both liquidity and convenience. Rather than owning thousands of individual bonds to replicate the holdings of an index benchmark, our investment professionals can be more discerning when it comes to security selection. For investors seeking to avoid some of the pitfalls of passive fixed income strategies, an active strategy that emphasizes higher quality bonds with favorable liquidity profiles could help. Additionally, we may use periods of heightened volatility to take advantage of perceived market mispricing.
3. T. Rowe Price combines multiple approaches into a comprehensive analytical process. We believe fundamental, macro, and quantitative analyses are all essential for actively managed portfolios. For each security, we perform a rigorous bottom-up evaluation that digs deep into a company’s current financials, future prospects, and industry trends. At the same time, our macro analysis focuses on how economic variables could affect both individual securities and the wider fixed income market. Finally, our quantitative team creates models and rules-based approaches that are used in the active management of bond portfolios.
Investor interest in actively managed fixed income ETFs has increased
(Fig. 1) Actively managed fixed income ETFs*, year-end total net assets, 2016-2023
*Total net assets include U.S. actively managed ETFs in taxable bond and municipal bond categories as defined by Morningstar.
Source: Morningstar; analysis by T. Rowe Price.
Is a fixed income ETF a good investment?
Determining whether fixed income ETFs are appropriate for an investor’s portfolio will depend on a variety of factors, including their existing investments, risk tolerance, income generation needs, long-term goals, and more.
However, fixed income ETFs may be worth considering for investors looking to incorporate a fixed income component into their portfolio. With fixed income ETFs, investors may be able to enjoy greater access to a wider selection of bonds than they otherwise would be able to participate in when purchasing individually. Because investors own shares of the ETF, as opposed to the underlying securities, they can also take advantage of greater liquidity—this is because it’s generally easier to buy and sell shares of stock on the market than to purchase and sell individual bonds.
Fixed income ETFs serve as a core component of client portfolios
With decades of experience over multiple market cycles, T. Rowe Price has a long track record of applying our repeatable, research-based investment process in pursuit of excess returns over our benchmarks. In creating our active ETFs, we believe investors stand to benefit from our long-standing strategic approach to investing in a convenient, cost-effective investment vehicle. T. Rowe Price has six distinct ETFs that together could form the core of an investor’s fixed income allocation:
Floating Rate ETF (TFLR): Invests primarily in institutional floating rate bank loans and other floating rate debt securities with below investment grade credit ratings. The fund is broadly diversified across 125–150 credit facilities, with strict exposure limits to manage risk.
QM U.S. Bond ETF (TAGG): Seeks to exceed the performance of the Bloomberg U.S. Aggregate Bond Index, a common measure of the domestic investment-grade bond market. The portfolio manager selects a set of U.S. dollar-denominated bonds that represent key benchmark traits while attempting to generate a modest amount of outperformance over the index.
Total Return ETF (TOTR): Invests in a diversified portfolio of bonds and other debt instruments. The fund has considerable flexibility in pursuit of strong portfolio returns and is constructed to be able to respond to a wide variety of market conditions.
U.S. High Yield ETF (THYF): Normally invests at least 80% of its net assets in U.S. high yield instruments (below investment grade). The fund focuses its investments on high yield corporate bonds but may also invest in other income-producing instruments, including bank loans, convertible securities, and preferred stocks.
Ultra Short-Term Bond ETF (TBUX):Invests in a diversified portfolio of shorter-term investment-grade corporate and government securities, asset-backed securities, and bank obligations. Invests at least 80% in bonds, and all of the securities purchased by the fund will berated investment grade at the time of purchase.
Intermediate Municipal Income ETF (TAXE): Invests primarily in investment-grade municipal securities or derivatives that are linked to or provide investment exposure to the municipal market. Seeks the highest level of income exempt from federal income taxes consistent with moderate price fluctuation.
Conclusion
Investors have long appreciated T. Rowe Price’s commitment to strategic investment management based on sound fundamental research and actively managed portfolios. Now, investors can access the benefits of our global resources and investment experience through our suite of active fixed income ETFs. After all, why settle for matching a benchmark when you could try to exceed it?
Additional Disclosures
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Important Information
Consider the investment objectives, risks, and charges and expenses carefully before investing. For a prospectus or, if available, a summary prospectus containing this and other information, visit troweprice.com. Read it carefully.
ETFs are bought and sold at market prices, not NAV. Investors generally incur the cost of the spread between the prices at which shares are bought and sold. Buying and selling shares may result in brokerage commissions, which will reduce returns.
This material is provided for general and educational purposes only. This material does not provide recommendations concerning investments, investment strategies, or account types. It is not individualized to the needs of any specific investor and is not intended to suggest that any particular investment action is appropriate for you. T. Rowe Price Investment Services, Inc., its affiliates, and its associates do not provide legal or tax advice. Any tax-related discussion contained in this material is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any tax penalties or (ii) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or tax professional regarding any legal or tax issues raised in this material.
Risk Considerations: All investments are subject to market risk, including the possible loss of principal. Fixed-income securities are subject to credit risk, liquidity risk, call risk, and interest-rate risk. As interest rates rise, bond prices generally fall. If interest rates rise significantly from current levels, bond fund total returns will decline and may even turn negative in the short term. Municipal securities will be highly impacted by the events and volatility of the overall municipal securities markets, including unfavorable municipal securities issuers, and the economy. State and local taxes may apply. A portion of the income distributions may be subject minimum tax. Active investing may have higher costs than passive investing and may underperform the broad market or passive peers with similar objectives. Passive investing may lag the performance of actively managed peers as holdings are not reallocated based on changes in market conditions or outlooks on specific securities.
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