In the past two years, retirement investors have funneled over $20 billion into US exchange-traded funds (ETFs) that limit both gains and losses, challenging traditional insurance products. These "buffered" ETFs capitalize on derivatives to cushion the effects of extreme market swings and have grown popular since their 2018 debut, especially after the market turbulence of 2020 and 2022.
The draw of buffered ETFs lies in their downside protection, which has become increasingly attractive to investors seeking to safeguard their retirement savings. Financial advisers in the US have embraced these ETFs, driving $10 billion in net inflows in both 2022 and 2023, while taking market share from the $3.3 trillion annuities market and costly structured notes.
This has grown not only the size but the scope of the market with 200+ defined outcome ETFs in the US, totally a staggering $37bn. In turn new competitors like BlackRock and AllianceBernstein are joining the competition to try and capitalize on the gains from First Trust and Allianz.
Finsum: The uniqueness of buffer ETFs really is in how they integrate derivatives to drive performance and outcomes and can present nearly all in one solutions.
What is the best way to manage a portfolio in an era with less structural disinflation, and how can you improve upon the 60/40 in the current environment
The traditional 60/40 portfolio, consisting of 60% stocks and 40% bonds, has long been a benchmark, balancing growth from stocks with stability from bonds. However, the historical success of this model relies on a period of declining interest rates and favorable economic conditions in the U.S., which may not persist in the future.
As interest rates stop declining and inflation potentially rises, the performance of the 60/40 portfolio is expected to be less impressive, especially during high inflation periods when energy and commodities tend to outperform. To better manage portfolios in this new environment, it’s advisable to diversify beyond the 60/40 mix by including assets like commodities, real estate, and cash equivalents to hedge against inflation and provide more stability during economic shifts.
Finsum: We have seen an increased correlation between stocks and bonds in the most recent years suggesting alternative diversification to manage volatility.
In its Q2 active fixed income commentary, Vanguard discussed lowering rate hike expectations for 2024 due to strong economic data, while inflation remains stubbornly above the Fed’s desired levels.
Despite the odds of a soft landing declining, Vanguard’s base-case scenario is that the Fed is done hiking and will hold rates at these levels until later this year. A risk to the firm’s outlook is inflation lingering above 3%, which would spark discussion about the need for further rate hikes.
It sees monetary policy as remaining data-dependent and notes that the Fed has limited room to maneuver. The central bank risks another surge in inflation by cutting rates too soon, but it also risks a prolonged recession by cutting rates too late.
Despite this uncertainty, Vanguard believes that there will be opportunities amid higher market volatility. It recommends investors take advantage of locking in attractive yields for longer durations and sees potential for better risk-adjusted returns in bonds vs. equities. Over the next 5 years, Vanguard forecasts returns of 4.5% for stocks and 4.3% for bonds. However, bonds are expected to have one-third of the volatility of stocks at 5.2% vs. 15.8%.
Finsum: Vanguard shared its quarterly active fixed income outlook. The firm is downgrading its expectations for rate cuts in 2024, given recent economic data. Instead, it sees more opportunities in other parts of the fixed-income market.
2024 has proven to be a year of relentless volatility for fixed income, given mixed signals about inflation, the economy, and monetary policy. However, there are plenty of opportunities to make money amid these conditions.
A consequence of high rates is that the US government is expected to pay more than $1 trillion in interest to bondholders this year, which is more than double the average from the previous decade. Currently, all Treasury securities are yielding more than 4%, and due to elevated rates, investors have a higher margin of safety. This means that fixed income is once again a source of meaningful income for investors and serves as a counterweight to equities.
Deal flow also remains robust, which is a positive for underwriters and sponsors. According to Bloomberg, bankers who underwrite bond offerings are expected to see a 25% increase in bonuses. In terms of sales and trading, bonuses are expected to rise by 20%, compared to an increase of 5% to 15% for equities.
Another trend in fixed income is the electronication of the bond market. Traditionally, bond trading has been done over the phone or through banks, which has resulted in illiquidity and less price discovery.
Now, volume is moving to electronic bond exchanges, which is benefiting market makers like Citadel Securities and Jane Street. These firms are now making markets in government and corporate bonds. It’s estimated that 42% of investment-grade debt trades were electronic last year, compared to 31% in 2021.
Finsum: Entering the year, many were confident that Fed rate cuts would fuel a bull market in bonds. This has failed to materialize, but there have been opportunities in fixed income.
April was marked by a mean reversion as robust inflation data and continued economic resilience dampened expectations of Fed dovishness later this year. As a result, flows into equity ETFs dropped from $106 billion in March to $41 billion in April.
In contrast, flows surged into fixed income ETFs, increasing more than 60% to $27.4 billion. Lower-risk government bond ETFs attracted the most inflows at $10.1 billion, which was the highest since October of last year. Within the category, short and intermediate-term Treasuries captured the most inflows.
In the US, flows into fixed-income ETFs were greater than equity ETF flows, at $15.2 billion vs. $14.1 billion. Scott Chronert, the global head of ETF research at Citi, noted “US-listed ETF flows decelerated this month against a generally risk-off backdrop. Underlying trends also pointed to more cautious positioning. Fixed income led all asset classes, but the gains were skewed towards core products, shorter durations, and Treasuries.”
Until something material changes in regard to inflation or the economy, it’s likely that investors will continue to favor ETFs that benefit from short-term rates remaining higher for longer.
Finsum: Fixed income inflows into ETFs sharply increased in April, while equity inflows declined. This was a downstream effect of reduced expectations of Fed rate cuts in the second half of the year due to an uptick in inflation.
Investors are finding increasingly innovative ways to invest in private markets and interval funds are one of the latest trends developing in this area. Interval funds enable individual investors to commit to strategies that invest directly in private markets, while listed private equity ETFs invest in public firms offering private-market strategies.
There has been a spike in interest for alternatives and uncorrelated assets, benefiting interval funds. High-net-worth investors now have access to private capital managers previously exclusive to pension funds and sovereign wealth funds, but accessing and managing the required capital remains a challenge. Private-market funds, including variously named private market access and opportunity funds, address this need and saw significant growth with 11 new products launched in 2022, a trend continuing in 2023.
Although these funds offer unique advantages like access and diversification, they come with high costs, potential liquidity issues, and commitment periods that can lock up capital, necessitating careful consideration by investors.
Finsum: Liquidity lock up should be highly considered for these types of alts, and the current high rate environment can exacerbate this problem.
In the past few years, the bond market has experienced increased turbulence as the U.S. Federal Reserve embarked on an unprecedented tightening cycle, successfully driving down inflation from 9.1% in June 2022 to 3.4% by the close of 2023. Despite the Fed's efforts to maintain stability since July 2023, fixed-income markets remain volatile, particularly in the 10-year U.S. Treasury yield. Throughout 2023, bond yields underwent significant fluctuations, reflecting market instability despite ending the year close to where it began.
Looking forward, uncertainties persist regarding economic growth and interest-rate policies, emphasizing the need for active management within fixed income. Prioritizing high-quality investments remains crucial amid mixed economic indicators and narrowing high-yield spreads, suggesting a prudent approach to portfolio diversification.
Furthermore, strategies involving duration positioning and sector rotation offer opportunities for active managers to capitalize on shifting market dynamics, highlighting the importance of adaptability and responsiveness in navigating bond markets.
Finsum: Fund managers can lean into historical analysis and precedent in volatility and factor selection could lead to more robust returns for active management.
Earlier this year, PIMCO cited expectations that the Fed would start a series of rate cuts as one of its reasons to be bullish on fixed income. The asset manager is revising this view given the lack of progress on inflation and now sees rate cuts being delayed until the end of the year or even into 2025.
Following the latest FOMC meeting, PIMCO sees the Fed pursuing a policy similar to the 1990s, when the Fed held rates and allowed inflation to trend lower over time. Fed officials seem wary of the downside risks of further tightening and are willing to concede higher inflation in the near term.
Despite a recent uptick in inflation, the Fed seems content to hold rates at steady levels. During his press conference, Chair Powell remarked that monetary policy was restrictive and that rates could be lowered if the labor market weakened. He added that a rate hike was ‘very unlikely’ and that the inflation in resurgence could be temporary due to seasonality and noise.
While fixed income rallied following the FOMC meeting, PIMCO expects FOMC members to raise their inflation forecasts from 2.6% to 3% for core PCE at the upcoming meeting. The firm also sees an increased risk of no rate cuts this year if inflation data comes in closer to 3% than 2%.
Finsum: Following the latest FOMC meeting and hot inflation data, PIMCO is lowering the odds of a Fed rate cut in 2024.
State Street is bullish on fixed income. It believes that institutions should take advantage of attractive yields and that macro conditions are improving, albeit in an uneven fashion. Investors can achieve their diversification, return, and income goals without compromising on credit quality.
Many pensions have been able to close or shrink their funding gaps due to higher yields from Treasuries and investment-grade corporate debt. At current valuations, bonds are able to more effectively function as a hedge against weaker economic growth and serve as an effective hedge against equities.
State Street sees the economy in a sideways period for rates and inflation. Therefore, it recommends that investors get long duration and see a more favorable environment eventually emerging for borrowers. It forecasts that inflation and Fed rates will end the year lower, providing a tailwind for fixed income.
In terms of active vs. passive strategies for fixed income, State Street takes a nuanced approach. It believes that in certain sectors, capable active managers have proven to add value. But this alpha has been shown to erode over time.
State Street has built a systematic approach towards fixed income which uses a rules-based approach. It weighs factors like value, sentiment, and momentum. It sees considerable benefits to increased electronic trading for fixed income, which has resulted in more data and liquidity.
Finsum: State Street is bullish on fixed income due to attractive yields and an improving macro environment. In terms of active vs. passive fixed income, it takes a nuanced view.
Stringer Asset Management shared some thoughts on fixed income, monetary policy, and the economy. The firm notes that while inflation has remained stubbornly above the Fed’s desired levels, it will move closer to the Fed’s target over time. One factor is that the M2 money supply is starting to decline, which is a leading indicator of inflation. Another is that fiscal stimulus effects are finally waning.
Thus, Stringer still sees rate cuts later this year, although it’s difficult to predict the timing and number of cuts, creating a challenging environment for bond investors. During this period of uncertainty, it favors active strategies to help reduce risk and capitalize on inefficiencies. Active managers are also better equipped to navigate a more dynamic environment full of risks, such as the upcoming election and a tenuous geopolitical situation.
Stringer recommends that investors diversify their holdings across the yield curve and credit risk factors. It favors a balance of riskier credit with Treasuries. This is because the firm expects the bond market to remain static until the Fed actually cuts. It’s also relatively optimistic for the economy given that household balance sheets are in good shape, corporate earnings remain strong, and the unemployment rate remains low. These conditions are conducive to a favorable environment for high-yield debt.
Finsum: Stringer Asset Management believes that fixed income investors should pursue an active approach given various uncertainties around the economy, inflation, and monetary policy in addition to geopolitical risks.
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Demand for US Treasuries continues to be strong despite high levels of issuance. According to the Treasury Department, foreign holdings of Treasuries saw their fifth monthly increase, reaching new highs.
As of the end of February, foreigners held $7.97 trillion of US Treasuries, nearly 9% higher than February 2023. Japan is the largest holder of Treasuries, outside of the US, at $1.17 trillion, which is the most since August 2022.
However, some believe that the country may be looking to boost the value of its currency, as it hit a 34-year low against the dollar earlier this week. In 2022, Japan intervened in currency markets by selling dollars and buying the yen when it was at similar levels. As a result, its holdings declined by $131.6 billion due to these transactions.
Another trend is that China’s holding of Treasuries continues to decline. The country held $775 billion in Treasuries, a decline of $22.7 billion from the previous month. This is the lowest amount since March 2009.
Europe saw the biggest monthly increase of $27 billion and owns $320 billion in total. Great Britain also saw a $9 billion increase in Treasury holdings to reach $701 billion.
Finsum: Despite recent volatility in US Treasuries, foreign holdings continue to rise. Japan remains the largest owner of Treasuries, while China continues to reduce its stake.
Bonds have weakened to start the year, given increasing uncertainty about the direction of the economy and monetary policy. Weitz Investment Management notes that credit spreads have tightened even while long-term yields move higher. Thus, the firm believes there is greater potential for losses if inflation meaningfully picks up from current levels or credit spreads widen.
It also believes that massive fiscal deficits are an indication that the inflation issue is not going to disappear anytime soon. It notes that over the last 4 years, deficits have averaged 9% of GDP, which was only seen before during wars. Currently, the national debt is increasing by $1 trillion every 100 days. And this is a major reason why the Fed’s aggressive hikes have not resulted in a recession. It also means that Treasury issuance will continue to be elevated as debt will need to be refinanced at higher rates.
Amid this backdrop, the firm notes that there is considerable complacency among investors. It notes that credit spreads declined across the board in Q1 and are now at 10-year lows. It believes this is likely a result of strong demand for bonds as new issues have been oversubscribed and there has been a flattening of yields in the credit curve.
To combat these risks, Weitz recommends looking for opportunities in fixed income across the spectrum and beyond the benchmarks. It recommends diversified and broad exposure, including fixed and floating-rate securities. Ultimately, investors need to be nimble and prepare for various scenarios, such as the economy continuing to be robust, inflation resuming its ascent, or the economy stumbling into a recession.
Finsum: Weitz Investment Management sees considerable complacency within fixed income while also noting some risks. It recommends investors seek broad and diversified exposure to the asset class and pursue a more active and nimble approach.
A major milestone occurred at the end of 2023 as assets in index funds exceeded assets held by active funds. The major factor behind this shift is an increasing preference for ETFs, while mutual funds are falling out of favor. While there has been much focus on the impressive growth rates of active ETFs, the larger narrative is that ETFs are displacing mutual funds, both active and passive.
According to Cerulli Associates, active ETFs had $129 billion of inflows last year, while there were $65 billion of inflows into passive mutual funds. In contrast, passive ETFs had inflows of $463 billion, while active mutual funds had net outflows of $576 billion.
A major factor is that ETFs have lower costs while also offering more transparency and liquidity. They are also more tax-efficient than their mutual fund counterparts. Additionally, many advisors are now focusing more on asset allocation than security selection, which is also contributing to growth of ETFs.
Cerulli also noted that more advisors are moving to independent firms from large broker-dealers. “Those advisors, according to our data, believe less in the merits of active investing,” remarked Matt Apkarian, Cerulli’s associate director of product development.
Another trend is that some portion of outflows from active mutual funds are going into active ETFs. Some new issues in the category have been gaining traction, and more asset managers are jumping on the trend.
Finsum: Last year, there were net inflows into active and passive ETFs and passive mutual funds. But there were huge outflows from passive mutual funds. A major factor is that ETFs are increasingly in favor due to lower costs and more transparency and liquidity.
For investors, Tax Day often brings financial woes as they grapple with income from their portfolios. Over two decades, U.S. equity mutual funds have consistently yielded 7% of Net Asset Value in capital gains, irrespective of market performance.
Direct Indexing emerges as a viable option, empowering investors to offset losses against gains within their portfolios or other income streams. Traditional portfolio management typically disregards tax implications, leading to hefty tax bills for investors, notably during market downturns like 2008.
Direct indexing offers a remedy, enabling investors to tailor their portfolios and strategically sell underperforming assets to counterbalance gains elsewhere. This method reduces turnover since the aim is to mirror an index with minimal trading. Even in bullish markets, avenues for loss mitigation exist, rendering direct indexing an attractive tax management strategy. By mirroring selected indexes, investors can curtail capital gains and potentially offset other income with net tax losses.
Finsum: Alpha and tax efficiency should be thought of in a similar lens and shouldn’t be discounted by advisors.