Welcome to Inside Active, a podcast about active managers that goes beyond sound bites and headlines and looks deeper into their processes, challenges and philosophies and security selection. I'm David Cohne, i lead mutual fund and active research at Bloomberg Intelligence.
For years, ETFs were almost synonymous with passive investing, but one of the biggest shifts happening in the markets right now is the rise of active, particularly in fixed income, where inefficiencies, liquidity differences, and security selection can matter a lot more. At the same time, firms like Vanguard, historically synonymous with low cost indexing, are leading further into active strategies within the ETF wrapper, reflecting both investor behavior and
portfolio construction are evolving. Soday, we're going to unpack with driving that shift across product design, investor behavior, and how active bond ETFs are actually being used. Joining me today today as my guest is Jeff Johnson, head of fixed income product at Vanguard. Jeff, thanks for joining me. Thanks David, it's great to be here. So let's start with the
big picture. Vanguard historically you know, known with indexing. What role to active fixed income ETFs play in Vanguard's broader product philosophy today.
That's great, That's a great place to start. And I think what I would say is that the conversation should still really start, in our view with what is the role of bonds in an investor's portfolio and getting that allocation right, and you know, the appropriate allocation to bonds, of course, as we all know, really depends from investor to investor based on their time horizon, risk tolerance goals, and in a variety of other needs that are very
specific to the investor. And from there, many investors, as we know, have a real preference for active investing in their portfolio, given the size of the fixed income market, the complexity of the fixed income market, the thousands of securities, the opportunities that present from the various inefficiencies that exist
in the fixed income market. Now for more than forty years, Vanguard has been providing that exposure to investors in the form of actively managed mutual funds, which have very clearly served investors very very well over the years. More recently, though, in recent decades, investors have increasingly shown a preference for ETFs. We first saw that really with the growth of ETFs in indexing oriented fixed income strategies, but more recently that has come together in the form of a broader array
of actively managed fixed income ETF. So, from the standpoint of our investment philosophy, we're most concerned with getting investors the right allocation to fixed income first and foremost, and then from there it really comes down to a choice and a preference between indexing air active and then the vehicle that is most suitable to that particular investor, whether it be you know, traditionally a mutual fund or increasingly going forward in ETF.
So how do you decide, you know, if you're thinking from product design and product launches which think that excuse me, fixed income strategies belonging an ETF wrapper versus mutual fund.
This is a timely question. As I said, our mutual fund lineup in fixed income goes back more than forty years, and we still very much believe in those funds and strategies they serve investors incredibly well. We have, on average a ten basis point weighted expense ratio across our life lineup that compares to forty six basis points for the industry.
Eighty eight percent of our funds have outperformed their peer group averages on a ten year basis, so we feel really great about the lineup when we are thinking about new product development. Though increasingly over the last couple of years, and this is probably going to continue to be the case going forward, the real preference and the real demand for investors has been for an ETF. We saw that first with index products. We're seeing that increasingly now on
the actively managed side. Actively managed ETFs pose certain unique challenges that we have to consider in the development and the design process that are somewhat different from the issues
that we've faced over the years with mutual funds. One of them has to do with the transparency and actively managed fixed income ETF discloses its full portfolio holdings on a daily basis, and what that means to us is in an active strategy, it's really important to ensure that the same sort of in some cases proprietary strategies designed to generate alpha or outperformance can persist in an actively managed ETF despite providing daily holdings transparency and potentially signaling
to the marketplace what kind of trading activity the portfolio management teams are up to. So that is one area in which as we think about the design of actively managed fixed income ETFs, at times there are certain modifications that we have to make to the portfolio or the process to accommodate that and still ensure that we're delivering top notch investment outcomes and the exposures that investors expect
in a given strategy. Another aspect, and probably the second aspect that would that I would call out that is really important for us to think about in active fixed income ETFs is size and scalability and capacity. At Vanguard, we're very proud to serve tens of millions of investors, but with that comes the obligation to really think about
how scalable are these strategies going to be. It's sort of been a good problem to have in the past that we've had to at times close certain funds because we need to preserve the manager's underlying ability to generate alpha, and as you and your listeners would know, sometimes large cash flows are large size can be an impediment to generating the same sort of ALP that you have in
the past. So anytime we're thinking about an actively managed product, we do have to think about how scalable it will be and ensure that we're not going to run into near term capacity constraints.
Yeah, definitely something I like to think about a lot, you know, looking at neutral funds versus ETFs. That's kind of like the big I think the more in the equity side, you know, where capacity is an issue, but your crag to fixed incum is also something to think about. And you know, Bakers launched several active fixed income ETFs in recent years. What gap and client portfolios were were you're trying to solve for and you know, and think about continuing to solve for going forward.
Yeah, I think of this not so much as a gap in client portfolios as an opportunity and a trend that it was time for Vanguard to participate in. You know, our first actively managed fixed income ETF was launched in twenty twenty one, that was the Vanguard Ultra Short Bond ETF. And a few years went by before we began to rapidly expand our lineup. And I think, in fact, David, one of your colleagues at times, has liked to joke that launching product Banguard is sort of like observing a
lunar eclipse because it happens so rarely. And I think over the last few years, it's been fair to push back on that a little bit and maybe say that it's maybe more akin to like the cycle of a full moon, because we've been a little bit more active launching active products. We've launched eight in the last two and a half years. And you know, that really came from a sort of a clear observance of a few
trends coming together. One, we've long known that investors have a preference or a bias for being active in their fixed income portfolios. There's no doubt been a growth of indexing, but it is still an asset class where the abundant the opportunities are pretty abundant for very skilled active managers. The other trend that was pretty clear is the increasing preference for the ETFs as a vehicle in ETFs as
the wrapper for the product. And as we saw these real trends converging and reflected on our deep expertise and capabilities managing ETFs, married with our more than forty years of history managing active fixed income very successfully, we felt it was really time to bring the Vanguard effect to
active fixed income ETFs. And as we set out on that journey, really had the opportunity to kind of blank slate, look at the market and say, all right, what kind of products, what kind of strategies are investors most gravitating towards? How have their needs evolved? And we've really concentrated our efforts in two areas. On the taxable fixed income side, there are a handful of very core building blocks that
investors are increasingly utilizing in their portfolios. When they show that preference for active management, you know, they like short duration strategies to be able to minimize the exposure to changes in interest rates. So we launched a short duration
core product. Investors continue to look for core and core plus fixed income strategies for those that are looking for an active alternative to an aggregate type benchmark, or an active alternative with some higher yielding sectors like like would be in the case in a core plus. We felt it was really important to offer exposures active investors, exposures
to active government securities. You know, there are times when investors are more interested in yield, but there's also times when it really pays off to have that high quality, very liquid fixed income ballast in the portfolio. And we're offering that now in the form of a government active ETF. And then for those investors who are looking to go farther out on the risk spectrum, high yield and multisector can be strategies that offer more of that income focus.
And then the second key category that we've seen is on the muni side, where we know that investors are very interested in controlling their tax obligations, and Vanguard has long been a leading provider of municipal bond funds. So offering a short duration and a core muni strategy really, at least at this phase one of our product build out, really completes the steps that makes sense.
You know, we're seeing really strong growth in active ETFs across all asset classes. Why is fixed income in particular, in your opinion, such fertile ground for active management in this wrapper.
I think this gets back to something that we were describing earlier. The market is so broad. There are about fourteen thousand securities in the aggregate index. There are opportunities for skilled managers to uncover value with disciplined processing these. There certainly are still cases in the fixed income markets
where bonds are less liquid. It's long been said that certain types of bonds trade by appointment only that that is still the case despite you know what's been you know, phenomenal growth in terms of electronic trading and optimization and automization in fixed income markets. Another factor that we can't ignore here, though, is that ETFs is a relatively new
technology still. You know, I think for some investors, we're looking for ETFs to prove that they could withstand a crisis, for ETFs to prove that they could really weather a storm, and they really did so with flying colors in twenty twenty again in twenty twenty two, when we saw significant
amounts of market volatility in both market environments. I think it really gave investors a lot of confidence that even though this is a vehicle where certain of underlying securities can sometimes be less liquid, the liquidity of the overall wrapper has proven to be extremely effective. So I think that's given investors a lot of confidence and fueled substantial amounts of growth for fixed income ETFs.
Okay, do you think active bond ETFs are gaining share because of performance, transparency, tax efficiency, or advisor adoption or some combination of the previous ones.
Well, David, I think the answer is all of the above. I think investors are are increasingly adopting active fixeding come ETFs because they appreciate the transparency, They appreciate the liquidity, they appreciate the increasing array of choice that they have
in terms of product design and offerings. I think, you know, while active ETFs, you know, still carry a slightly higher expense ratio than index ETFs, buy and large active ETFs have come to the market at a at a bit more of an attractive price point than actively managed funds. More and more investors are really appreciating, you know, what Vanguard has long espoused in terms of you really get what you don't pay for when it comes to investing in. The lower expense ratio means that you get to keep
more of that return for yourself. The flexibility and the liquidity again, those are just all features that investors are increasingly gravitating towards. And we really don't see that slowing down anytime soon.
So if we think from five years from now, what percentage of Vanguard's fixed income ETF assets do you think will be active? Oh?
Man, I would have a hard time putting a number on that figure. I think, you know, when we look though at what we saw in twenty twenty five, that's probably fairly indicative of where the industry is headed. There were about six hundred billion dollars in flows into fixed income in twenty twenty five, and that was pretty evenly split between index and active, but roughly seventy percent of the flows were into ETFs, So it is increasingly the
vehicle of choice. So I would expect our share of ETFs as in terms of vanguards overall fixing umbiga business to continue to climb.
Okay, And you know, if we think about right now fixed income, right now, where do you where are you seeing cash flow going in terms of the fixed income market ultra short core munis.
There have been some important shifts here over the last few years. I think kind of have to start the conversation in some ways with what happened in twenty twenty two and twenty twenty three. Investors were very much you know, I think, startled by rapid moves and interest rates inflation, and they saw declines on bond market benchmarks that they weren't a customed to seeing. It had been you know, decades since they had seen those sorts of losses in
fixed income. The good news there was by and large and vanguard investors were very well behaved. I think we've all always done a pretty good job of attracting investors who buy into our investment philosophy, our investment principles around you know, having clear goals, being balanced, being disciplined, focusing on low costs. So they took the volatility in stride.
That all said, I think we saw a lot of the same trends that the rest of the industry saw, which was investors favoring shorter duration strategies, a lot of cash oriented strategies in recent years, and this was definitely the case in twenty twenty five, and it persists. Investors have been creeping out the curve and they've been looking to take on more risk and generate more income and yield in their portfolios, and the opportunity has really been
ripe for that. In the active fixed income category, a lot of demand for core, core, plus and multi sector
type strategies. And some of that speaks to the real appreciation that investors seem to have in active fixed income for intrusting very talented, skilled managers with the flexibility to move across sectors and identify value where their teams see the greatest amount of opportunity, and I would contrast that somewhat with what we see in index fixed income flows, which is probably more broad based demand and in some cases investors looking for indices to target more narrow exposures
and get their beta exposure that way.
So you think, you know things have changed, is the rate shock of twenty twenty two, and you're seeing investors extending duration again, we.
Are seeing that, we're seeing them extend duration. We're seeing them look to you know, corporate and higher US yielding sectors to pick up yield. You know, I would I would remind them that the market environment is still one that is characterized by a great deal of uncertainty. Uh. You know, there's certainly uncertainty from a geopolitical standpoint. We're going to be going through a transition of leadership at the Federal Reserve. You know, inflation is still very much
on people's minds. Be our word has crept in more recently as as you know, tensions in the Middle East have have escalated. So, you know, while we still see attractive opportunities in in core plus and higher yield type sectors, but still remind investors that government bonds, you know, inflation linked bonds can play a real role in their portfolio from a diversification standpoint, and can come in real handy if we do see periods of increased volatility.
What role do you think active bond ETFs are playing in model portfolios today compared to I don't know, like three years ago.
Yeah, model model portfolios are UH, you know, very much a growth engine, particularly in the financial advisor space. UH and and models have been a driving force behind the adoption of fixed income indexing ETFs, in part because a lot of advisors are looking for very specific exposures UH to UH sectors of the fixed income market, whether it's
short duration, long duration, corporate treasury, mortgages, high yield. So, you know, indexed et s within model portfolios have been a very effective tool for advisors to be active with their acid allocation, but sometimes deploy those those views in a passive way through a through an indexed vehicle. What we're seeing on the on the active et F side, though, are are UH the ability for advisors to build model portfolios that capture sort of the breadth of a team's
best ideas in an active ETF. So we see, you know, real growth for strategies in particular like core bond or coreplus bond active ETFs, which tend to be a very strategic and core element of ETF models.
If we go beyond model portfolios and think of advisors that are doing, you know, selection on their own, are you seeing them use active bond ETFs differently than index bond ETFs.
There are some nuanced differences here, And as we've kind of talked about a little bit already or alluded to, I think it's long been the case that investors have a bias in fixed income towards being active because of the opportunities and the inefficiencies, and the breadth and complexity of the market. And it was only just in twenty twenty five that index flows were about on par with
with active flows across the intry. For twenty five years, I've been in and around fixed income markets, spoken to a lot of investors, spoken to a lot of clients. I haven't met too many fixed income investors who are purely passive. Most fixed income investors are active at a minimum when it comes to setting the acid allocation. They're thinking about what are their unique goals, what's their time horizon,
How important is liquidity in their portfolio. How comfortable are they going down the credit quality spectrum in picking up additional yield? Our taxes important to them are not. These are all very very active decisions that a fixed income acid allocator must weight make when building their portfolio. And the great news for them that's emerged over the last ten years or so is that they have an incredible amount of choice now if they want to be very
active with that decision making. From an acid out location standpoint, they have an abundance of tools that allow them to position a portfolio and deploy their views actively but potentially using underlying index vehicles that track those benchmarks that reflect
their active points of view. In other cases, we continue to see fixed income investors looking to active managers to scan the universe and look for the best opportunities capitalize on the value that's available, and increasingly what we're seeing is that they're showing a preference in active vehicles towards the broader, more flexible fixed income strategies that give the managers the latitude to move across investment grade or high
yield or emerging markets or in some cases currencies, maybe mortgages, securit tights securitize sectors to find the best value wherever it exists at that point in time.
So I kind of want to go a little deeper. You know, yields are obviously meaningful higher than they were. I don't like a decade ago. Do you think the conversations changed about you know, taking credit risk for you know, whether it's advisors or individual investors.
Well, you're right, yields. Yields are higher, and higher yields have changed the conversation a little bit that we're able to have with investors. You know, it wasn't too long ago that investors were you know, pretty you know, pretty bothered by the very low yield environment. There wasn't a lot of income available that has has no doubt changed. It's changed so much, in fact, that Vanguard's own longer term economic outlook has you know, fairly comparable expected returns
between stocks and bonds. This is an environment where you know, we think investors at least need to be thinking about a sixty forty portfolio, if not forty sixty. And that's especially the case in the market environment like we have today, when they're is you know a great deal of uncertainty and we've seen increases in volatility. Some investors are still nervous about what could happen if rates rise or if
you do get in inflation shock. But the good news is is that when you have a core strategy that's yielding upwards of four percent, you do have a built in yield cushion, so that if yields do go up from here, the good news is that you're going to be earning higher yields from here. The other good news is that you know that higher yield that you're starting out with provides a little bit of a buffer from any sort of capital losses that take place in the shorter term.
So the fixedick and ETF ecosystem has evolved pretty rapidly. How do you think about liquidity and active bond ETF, especially in less liquid sectors.
You know, really, we think about it very similarly as we do thinking about liquidity in are actively managed fixed income mutual funds. These are all broadly diversified strategies. We have a liquidity framework and a toolkit for all of our active strategies. We're very disciplined about maintaining dry powder in these portfolios to help ensure that the managers always have the flexibility to take advantage of opportunities when the
market presents them. I think the experience that Vanguard has going back decades managing ETFs on the index side has allowed us to build out years and years of technology and expertise and experience through different cycles managing ETFs, developing
that ecosystem, developing a capital markets ecosystem. I think this combination of our active history, our index history, and our ETF history kind of provides a unique combination and value proposition to investors looking for kind of the best of all of those things in active fixed income ETFs.
Okay, and what differentiates Vanguard's approach to active fixed income ETFs from peers who may want to emphasize things like higher yield or more tactical positioning.
Sure, uh, you know, for for forty years, For more than forty years, Vanguard has been managing active fixed income you know, according to you know, a few key principles. Number one, it really starts with having a deep bench of experts with more than two and a half trillion dollars in fixed income assets under management and more than
two hundred fixed income investment professionals globally. You know, there's just no question that you need a deep and experienced and talented team uh TO to to manage this market. Another component of our approach that we're proud of and that it's differentiated in the marketplace is that it's very much a team oriented approach. You won't hear us talk a lot about star portfolio managers. Doesn't mean that we
don't have stars on the team. I think we think of all of our pms as being all stars and a team of stars. But this team based approach, this highly collaborative approach, you know, really allows us to share the best insights and the best ideas across all of our portfolios. You know. I think a third aspect of the strategy is really just the consistency and having a
repeatable and durable process. And what's most important there is focusing on the most repeatable sources of alpha generation, and for us, that really starts with security selection being repeatable and reliable and durable through different market cycles more so than timing rates increasing or decreasing the duration, so that allows us to have very consistent investment outcomes. And then finally, I think we couldn't be talking about the Vanguard offer
without the cost advantage. Our low costs combined with the repeatable process and the deep and talented team means that investors get to keep more of what the market is providing them. And that's just such an important dynamic and fixed income where in general, over time, you're talking about an asset class that's going to have a lower expected return than others like equities traditionally or maybe even private investments for those investors who are going to incorporate those
in their portfolios. So being able to keep more of what they earn has been an important engine behind eighty eight percent of Vanguard's fixed income funds outperforming their peer averages over ten year periods of time.
Well, it certainly seems like active fixing of metfs is going to be a big growth area for your firm, and you know, I'm looking forward to seeing what's next. But unfortunately we need to end here. But this was great, Jeff, Thanks thanks again for joining me anytime. Thanks David, all was a pleasure. I also want to thank our listeners. If you liked the episode, please share, subscribe, and leave a review. And if you'd like to see more of our research on the terminal, go to bifund go for
fund and Active Research until our next episode. This is David Comb inside Active