FIXD: Active Fund Outperforming The US Aggregate Bond Index

Thesis

The First Trust TCW Opportunistic Fixed Income ETF (NASDAQ:FIXD) is a fixed income exchange traded fund. As per its literature:

The First Trust TCW Opportunistic Fixed Income ETF is an actively managed exchange-traded fund. The Fund’s investment objective is to seek to maximize long-term total return. Under normal market conditions, the Fund pursues its objective by investing at least 80% of its net assets (including investment borrowings) in fixed income securities.

Source: Fund Description

In effect FIXD is an active ETF that seeks to track and outperform the Bloomberg US Aggregate Bond Index. The best known ETF in the space tracking the respective index is the iShares Core U.S. Aggregate Bond ETF (AGG), so in this article we are going to benchmark FIXD against AGG, a passive fund:

A passive exchange-traded fund (ETF) is a financial instrument that seeks to replicate the performance of the broader equity market or a specific sector or trend. Passive ETFs mirror the holdings of a designated index—a collection of tradable assets deemed to be representative of a particular market or segment.

Source: Investopedia

Conversely, active funds take more risk in certain holding sleeves either via duration or credit risk, in order to outperform the index and their passive peers. FIXD does charge more as an active fund, with its expense ratio at 0.65% versus 0.03% for AGG. Ultimately though total returns matter, and FIXD managed to post an incremental return of over 120 bps when compared to AGG in the past six years.

The fund is slightly more volatile than AGG, but its risk metrics are very much comparable:

We can see FIXD with a slightly higher standard deviation and beta, but a very similar Sharpe Ratio. The fund does not seem to take outsized risks versus its benchmark, yet has managed to outperform.

The composition here is mostly investment grade bonds, which make up over 80% of the collateral. Treasuries and MBS bonds are the highest sleeves here, making risk free rates the main risk factor for this fund. With a cooling inflation picture, the market is now debating whether the forecasted July rate hike will be the last one this cycle. We had been of the opinion that the last hike would see the end of the cycle, but data came in much stronger than expected. Real rates are now firmly in positive territory, which makes the argument for additional hikes more muted:

In the above graph the blue line represents the ‘Real Fed Policy Rate’, which is calculated using risk free rates minus inflation. A positive real rate is restrictive, while negative real rates indicate that inflation adjusted federal policy is accommodative.

Holdings

The fund is overweight investment grade fixed income which makes-up over 80% of the collateral pool:

The main sleeves in this fund are represented by AAA securities, namely Treasuries and Agency MBS bonds:

The fund also contains Non-Agency MBS securities, which are securitizations of loans which are not guaranteed by the government:

As a quick reminder, non-agency RMBS are securitized bonds backed by residential mortgages from across the U.S. They differ from the Agency RMBS market because these securities do not have the implicit guarantee of the federal government (i.e., Fannie and Freddie). From a practical standpoint, the majority of the non-agency RMBS market consists of seasoned pools that are priced at a discount. Lastly, they provide fixed income investors access to an improving housing market and a healing consumer with less interest rate risk since the majority of the asset class is floating rate.

Source: Angel Oak Capital

The portfolio duration is roughly 7 years, with the weighted average life of the underlying securities close to 8 years:

Performance

The fund has managed to outperform the (AGG) benchmark during certain periods in time:

The violet line in the above graph represents (FIXD), and we can see the fund posting total returns slightly higher than AGG during certain periods in time, especially during the zero rates market rally in 2020/2021. From a calendar standpoint, this is how the performance shakes out:

FIXD is slightly more volatile than AGG, but ultimately does produce a total return performance that is superior, albeit only slightly.

Risks to a Buy Thesis

As discussed above the main risk factor for this fund is represented by risk free rates. The Fed has moved rates higher on the back of strong inflation numbers, inflation which is now moderating. For FIXD to experience another negative year we need to see rates move higher from today’s levels by at least 100 bps (given the fund’s duration that would negate the carry). That is not what the forward market is telling us with rates peaking close to the current Fed Funds levels.

Conclusion

FIXD is a fixed income exchange traded fund. The vehicle is an active one, trying to outperform the Bloomberg US Aggregate Bond Index. The ETF charges higher fees when compared to the passive industry standard iShares Core U.S. Aggregate Bond ETF (AGG), clipping 0.65% for its active management versus 0.03% for AGG. FIXD however does manage to achieve its goal, having posted an incremental return of over 120 bps in the past six years when compared to AGG. The fund is slightly more volatile, with a higher standard deviation and beta, but its analytics are only marginally worse. FIXD is an investment grade bond fund, overweight Treasuries and Agency MBS bonds, thus rates represent the largest risk factor here. We are of the belief we are witnessing peak rates, and expect positive returns from bonds in the next 12 months. We are penciling in a positive +12% return from FIXD in the next year, coming from its carry (roughly 5%) and an expected 7% NPV gain from a 1% parallel shift down in the yield curve in the next year.