Eugene Fama and Kenneth French’s landmark research on the influence of various factors on portfolio returns helped spur the massive growth in the smart beta funds category. Morningstar says roughly $800 billion is now invested worldwide across 1,500 factor-based exchange-traded products, up from around $600 billion two years ago. (Factor investing and smart beta are mostly interchangeable terms.)

Typically, the factor story has been about equities. But now bonds are likely to get their turn in the factor spotlight.

Exchange-traded fund sponsors have been rolling out fixed-income ETFs pegged to the same factors they have been using to evaluate stocks—by their value, quality and momentum. This relatively new genre of funds straddles the line between low-cost passive ETFs and higher-cost actively managed funds. And there is a growing body of empirical evidence suggesting that factors can aid credit investing in a robust fashion. Strategists at Invesco have analyzed fixed-income markets over the past decade and found that factors may have played a role in the typical fixed-income manager’s outperformance.

The cost of actively managed bond ETFs can be surprisingly high. Bond giant PIMCO, for example, charges a 1.09% expense ratio for its PIMCO Enhanced Low Duration Active ETF (LDUR) and 0.76% for the PIMCO Active Bond ETF (BOND).

Todd Rosenbluth, director of ETF and mutual fund research at CFRA Research, says factor-based bond ETFs deploy “tools being used by actively managed bond funds, but at much lower cost.”

And given the current low-yield environment for most bonds, every penny matters. “Even if you can save 25 basis points in fees per year, that can really add up,” says Karen Schenone, fixed-income product strategist at iShares. There are five iShares bond factor funds with an average expense ratio of 0.28%.

There’s one small challenge in the bond factor approach. As Greg Friedman, Fidelity’s head of ETF strategy and planning notes, “Fama and French built their research on equities.” Still, his firm and others have back-tested fixed-income returns using factors and found that they have delivered alpha over time.

The short track record for these funds creates another conundrum. Schenone says that “the understanding and knowledge of these funds are still low,” adding that many investors want to see three-year or even five-year track records before buying in. “Anyone launching bond factor funds needs to be in it for the long haul,” she adds. “It will take time to demonstrate that performance.”

Most of the factor-based funds have yet to amass a sizable asset base. “The strategies sound appropriate, but investors have been slow to adopt them,” says Rosenbluth. “There’s an education challenge here. It’s not the simplest approach to explain.”

Fidelity is taking the long view with the Fidelity Low Duration Bond Factor ETF (FLDR) and the Fidelity High Yield Factor ETF (FDHY), both of which launched in June 2018. The former uses a rules-based process to optimize the balance of interest rate risk and credit risk so that both return and risk measures may be improved relative to traditional benchmarks. The latter is an “actively managed ETF leveraging a quantitative model to select investments,” according to Fidelity, and applies value and quality factors to find high-yield bonds with strong return potential and low probability of default.

Neither fund has yet to crack the $100 million mark. “We don’t look at AUM as a measure of success,” says Friedman, though he adds Fidelity is seeing steady asset growth with the funds.

Rob Waldner, chief strategist and head of multi-sector fixed income at Invesco, believes it’s only a matter of time before these new funds gain traction. “This approach is so well-established in the equity sphere, and we think that factor-focused bond investing will also grow in popularity over time,” he says.

The early results with this approach are promising. The iShares Yield Optimized Bond ETF (BYLD), for example, is cited as the top-performing “core plus” bond fund, according to Morningstar. The fund has a 0.20% expense ratio and had $63 million in assets as of this year’s second quarter. It topped the Bloomberg Barclays U.S. Aggregate Bond Index by 50 basis points, on average, over the past five years.

Screening For Quality

Much of the focus in this factor-based bond ETF category has been on high-yield, or junk bonds, which are vulnerable to defaults if the economy slips into recession. Though these newish ETFs—many of these high-yield products have rolled out within the past two years—deploy screening processes to weed out bonds of lower quality, we won’t know how they will perform until weaker economic conditions arrive.

The growing roster of quality-focused high-yield choices includes the aforementioned Fidelity High Yield Factor ETF, the iShares Edge High Yield Defensive Bond ETF (HYDB) and the IQ S&P High Yield Low Volatility Bond ETF (HYLV). These funds charge between 0.35% and 0.45%.

The IQ fund is based on an index that looks at the liquid U.S. high-yield bond universe, takes spread and duration into account, and then tracks the half of the market that scores best. “We’re getting 75% of the high yield with 67% of the volatility,” says Sal Bruno, chief investment officer at IndexIQ.

Invesco aims to undercut the competition on price by charging a lower 0.23% expense ratio for its own version of a quality-screened high-yield play, the Invesco Corporate Income Defensive ETF (IHYD). And the firm goes beyond high yield, applying the quality screening approach to the Invesco Investment Grade Defensive ETF (IIGD, which charges 0.13%) and the Invesco Emerging Markets Debt Defensive ETF (IEMD, which charges 0.29%).

The IEMD fund in particular appears well built to tackle the twin challenges of emerging market bonds: currency risk and economic risk. The fund focuses on bond issues of shorter duration that have higher-than-average credit ratings. The average holding in the fund matures in 2.46 years and has a weighted average coupon of 5.18%. By focusing on shorter-duration bonds, this fund is less exposed to the wide bands that currencies can trade over longer time periods.

Bond Momentum?

Momentum investing with equities is a fairly straightforward concept, but such an approach is harder to replicate with bonds.

“There are a lot more CUSIPs [i.e., individual securities] with bonds, so it’s a market that is a lot harder to track,” says Invesco’s Waldner. As a result, fixed-income-focused factor funds shift their assets toward entire bond classes such as short-term bonds, high-yield bonds and emerging-market bonds.

Momentum-focused bond funds have had to navigate tricky waters, says Bruno. In the past 12 months, the Fed has pivoted from a course of rate hikes to an increasingly likely path of interest rate cuts. “[Bond] momentum doesn’t work well during inflection points, such as when the Fed changes course on policy,” he says.

His firm’s IQ Enhanced Core Bond U.S. ETF (AGGE) uses a momentum investing strategy that seeks to capitalize on the persistence of ongoing market trends, according to the fund literature. Bruno says the approach worked well in the early years after the fund was launched in May 2016, but has struggled during the more recent period of bond market volatility. As a result, the fund’s three-year annualized return of 1.12% has trailed the benchmark Bloomberg Barclays U.S. Aggregate Bond Index by more than a percentage point per year.

The rapid shifts in interest rate policy over the past year indicate that the once-boring bond market may be poised to remain in a volatile state for the foreseeable future. A cloudy outlook for the direction of interest rates, stunningly large government budget deficits around the globe and an unprecedented level of executive branch jawboning about central bank policy means that the decade ahead for bonds could be quite different from the past decade. Applying value, quality and momentum factors to fixed-income sleeves may help to smooth out the peaks and valleys.