If there’s been one major story for investment funds in recent years, it has been the continued rise of ETFs. From the recent ETF share class news to spot crypto ETFs, the vehicle provides a canvas for asset managers to create new and powerful investing tools. More important, perhaps, than any other development in the ETF wrapper may be the rise of active ETFs. Now could be the time to make the switch to active fixed income ETFs, specifically.
More and more active products are launching each year, representing a growing percentage of each year’s crop of new ETFs. Active equity ETFs have taken up a lot of that attention and oxygen, but active fixed income ETFs may be poised to star in the closing weeks of 2025 and beginning of 2026.
Get Active as Interest Rate Uncertainty Grows
Why active right now? Perhaps the biggest factor is the uncertain picture around interest rates. September’s rate cut has not been followed by further cuts — at least for now. While Federal Reserve Chair Jerome Powell hinted this month that the central bank may be leaning toward further cuts, it continues to balance its dual mandate.
“If we move too quickly, then we may leave the inflation job unfinished and have to come back later and finish it,” he said, per CNBC. “If we move too slowly, there may be unnecessary losses, painful losses, in the employment market. So we’re in the difficult situation of balancing those two things.”
Active fixed income ETFs offer the flexibility to adapt and seek out the best offerings for that uncertain moment. Active core bond funds, for example, often have a wide remit to deliver for investors, able to adjust quickly compared to passive funds.
For those investors at or near retirement who rely heavily on bonds in their portfolios, adding adaptability for that uncertain rate picture matters. If, for example, the Fed cuts rates further, active funds can help find strong yields in new offerings as needed. If the Fed holds off, active managers can adapt to the yield curve as needed to keep delivering for investors.
A Fundamental Issue in Passive Bond Funds
Even in a simple, predictable market, however, with steady rates and 3% growth, passive bond funds would still face an issue relative to their active peers: tracking errors. Passive bond funds must attempt to replicate their index as part of their core investing approach. While there’s no problem in doing so in equities — whether such an approach actually performs well or not — it’s not so simple in bonds.
Even in steady fixed income environments, some bonds may be called early or default. Issuers may sometimes have credit risks investors or index crafters do not discover until they become a problem. Those types of occurrences can create small but impactful differences between the index a fund tracks and what the fund actually holds.
Where passive managers have to wait to adjust and swap in bonds to maintain the weights mandated by their indexes, active managers can move much more quickly. Not only do active fixed income ETFs provide that responsiveness to that fundamental issue to index tracking, but the ETF wrapper’s transparency, too, makes such funds easier to follow and understand for investors.
Active Fixed Income ETFs Can Lean on Fundamentals to Seek Outperformance
Finally, active fixed income ETFs have one more strength that can help in the current moment. Their ability to leverage fundamental research to identify the strongest issuers and opportunities can offer greater performance, potentially, than passive funds. The Agg may have its merits in terms of predictability, and as a benchmark, but the right active approach can find opportunities therein.
For example, an active ETF focused on a particular category where credit ratings matter a lot, like high yield, could outdo passive rivals. A passive fund may have certain strictures limiting how it crafts its portfolio, like geographic or issue credit rating limits. An active fund can use its greater remit to produce, potentially, better yields.
Taken together, active fixed income ETFs offer some potential improvements for many investors’ portfolios. Looking at the uncertain fixed income landscape ahead, investors and advisors may want to consider where their own bond allocations may benefit from a shift to active ETFs.
Originally published on Advisor Perspectives
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