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Fixed income ETFs: The benefits of an active approach

Passive approach not the most effective when investing in bonds

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Many investors today view passive investment strategies as inherently less risky than their active counterparts, often favouring indexed solutions due to their transparency and lower cost characteristics. However, contrary to popular thought, a passive investment approach may not necessarily be the most effective, or low risk, way to access financial markets, particularly with respect to fixed income investing.    

The very nature of the way the bond market is structured – together with key differences in the way fixed income indices are constructed when compared to equity indices – means investors can find themselves exposed to a number of unintended risks and consequences in their search for yield.

The following four points highlight some of the limitations inherent in a fixed income index approach: 

  1. Index weightings favour heavy debtors: Bond indices are issuance-weighted, meaning the more debt a company or government issues that meet the index criteria, the larger the relative weight it holds in the index as well. Consequently, a passive investor can unintentionally find that they are increasingly exposed to issuers that are expanding their debt load.

  2. Market forces ‘passively’ adjust index composition: A passive product must follow index migration, irrespective of investment merit or market insight. An active manager can proactively respond to market events and changing investment cycles to help mitigate the shifts that may change the risk/reward profile of a portfolio based on their research.

  3. Full replication of fixed income indices is impossible to achieve: Bond indices typically have large numbers of constituents, with multiple bonds issued from the same issuer, some of which may not trade on a daily basis, making it very challenging for passive investment strategies to fully replicate the index. Instead, many use a sampling methodology in an attempt to build a similar allocation, but necessarily deviating from the index itself.

  4. Different buyers lead to differing outcomes: Bond markets have many different buyers, with varying reasons for buying. A significant amount of global fixed income assets are held by central banks and those trying to stabilise foreign exchange rates and adjust money supply, and their goals may share little with those of retail investors seeking diversification, income and/or total return. As a result, bond indices can be shaped and moved by many disparate forces, some of which may be far from supportive for the average investor.

We believe an active approach to fixed income investment can help deliver outcomes that are more in line with investors’ goals and expectations. At Franklin Templeton, we base our actively managed decisions on each investment’s potential for strong risk-adjusted returns, not constraining our choices to the size limitations of the specific index weightings.

And as active managers, we can decide to invest outside the benchmark as well as over/underweight positions relative to the benchmark if our bottom-up analysis dictates. This is particularly important in nascent markets such as the green bond market where any new, large issuance will create a large weight within a green bond index.

By contrast, through active management, our portfolio managers have greater flexibility to continuously benchmark each green bond against its peers and move into issues that offer greater relative value.   

Our approach has been tested for over 40 years and Franklin Templeton now manages over $650bn in fixed income assets across the full spectrum of strategies – including core, credit, unconstrained, emerging market and single-country – in a variety of investment vehicles, to help you create the right portfolio for your clients.    

Our range of actively managed fixed income ETFs – which offer all the liquidity, transparency and low-cost benefits inherent in the ETF structure – include:

ISIN

TER

Franklin Liberty Euro Green Bond UCITS ETF

IE00BHZRR253

0.30%

Franklin Liberty Euro Short Maturity UCITS ETF

IE00BFWXDY69

0.15%

Franklin Liberty USD Investment Grade Corporate Bond UCITS ETF

IE00BFWXDX52

0.35%

Important Legal Information

This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.

Franklin LibertyShares ICAV (“the ETF”) investment returns and principal values will change with market conditions, and an investor may have a gain or a loss when they sell their shares. Please visit www.franklintempleton.co.uk for the Franklin LibertyShares ICAV standardised and most recent month-end performance. There is no guarantee that any strategy will achieve its objective.

All performance data shown is in the fund's base currency. Performance data is based on the net asset value (NAV) of the ETF which may not be the same as the market price of the ETF.

Individual investors may realise returns that are different to the NAV performance. Past performance is not an indicator or a guarantee of future performance. The actual costs vary depending on the executing custodian. In addition, deposit costs may be incurred which could have a negative effect on the value. Please find out the costs due from the respective price lists from the processing/custodian bank. Changes in exchange rates could have positive or negative effects on this investment. Please visit www.franklintempleon.co.uk for current performance and see the latest prospectus or supplement for further details. Information is historical and may not reflect current or future portfolio characteristics. All portfolio holdings are subject to change.

An investment in Franklin LibertyShares ICAV entail risks which are described in the latest prospectus or supplement and in the relevant Key Investor Information Document.

Franklin LibertyShares ICAV (domiciled outside of the U.S. or Canada) may not be directly or indirectly offered or sold to residents of the United States of America or Canada. ETFs trade like stocks, fluctuate in market value and may trade at prices above or below the ETFs net asset value. Brokerage commissions and ETF expenses will reduce returns.

Issued by Franklin Templeton Investment Management Limited (FTIML)

Cannon Place, 78 Cannon Street

London EC4N 6HL

Tel:  +44 (0)20 7073 8500

© 2020 Franklin Templeton. All rights reserved.

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