Portfolio perspectives

The rise of active fixed income ETFs: What you should know

Over the past decade, financial advisors have increasingly favored ETFs and their characteristics for accessing active strategies. It’s easy to see why.

Compared with mutual funds, ETFs offer distinct advantages, including ease of trading and implementation owing to their exchange-traded nature, as well as the potential for lower all-in costs through reduced trading expenses and, in some cases, lower expense ratios. With that backdrop, it’s no surprise that active managers across equities and fixed income have gravitated toward the ETF wrapper to match these preferences. Within fixed income, we have seen a rapid adoption of active ETFs, which account for more than 40% of the cash flow over the past year and represent nearly 20% of total assets invested in fixed income ETFs.¹

Due diligence required for active fixed income ETFs

Over the past decade, the number of active ETFs available has surpassed the number of index ETFs, with some active strategies attempting to mirror existing mutual funds from asset managers.¹ A key theme emerging in recent conversations is advisors adopting these ETF “siblings” of mutual funds that they know and allocate to in their model portfolios. At the same time, our discussions with advisors have revealed a handful of challenges, including unexpected investment outcomes, when assuming the ETF is equivalent to the mutual fund. To take the sibling analogy a step further: These products can range in similarity from near twins to cousins. When assessing these products, we encourage advisors to consider these three due-diligence questions:

• How is the ETF similar to or different from the mutual fund?
• If it is different, how meaningful are the deviations?
• How will those deviations influence the strategy’s performance?

While the ETF may seek the same objectives, fit in the same category, and even share a common name, material differences may exist that could easily be missed without proper due diligence. Some of the common differences we see include:

1.  Portfolio management. Portfolio management team, philosophy, process, exposures, and risk-budget may all differ between the ETF and mutual fund. This is the first thing to check to ensure the ETF is actually an equivalent product. Any differences in these categories can create meaningful performance differences from the mutual fund and require a fresh approach to due diligence.
2.  Issuer’s experience running ETF portfolios. There are material differences in operating ETFs and mutual funds, including those highlighted here. ETFs require a different set of operational requirements than mutual funds, and those requirements take time, expertise, and experience to master. Make sure your provider has a track record in this space.
3.  Performance. If the team, process, and provider all check out, performance can validate whether the ETF truly aligns with its mutual fund counterpart. But remember that past performance isn’t a prologue—it’s simply a clue. Use it as part of a broader due diligence lens.

Potential solutions to consider

As ETF adoption accelerates, the temptation to swap a mutual fund for its “equivalent” ETF will only grow. But don’t assume equivalence—verify it. Make sure the ETF is managed by the same team, follows the same philosophy, and is backed by a provider with proven expertise in fixed income ETF management.

At Vanguard, we've been managing fixed income ETFs since 2007 and offer ETF versions of several active mutual fund strategies that are substantially similar in management team, approach, and execution. Examples include Vanguard Core Bond ETF (VCRB), Vanguard Core-Plus Bond ETF (VPLS), and Vanguard Multi-Sector Income Bond ETF (VGMS).

If you're considering making a switch or simply want to understand how Vanguard approaches active fixed income ETFs, reach out to your Vanguard representative for more information.