As smart beta products age and build assets, most advisors have become familiar, if not comfortable, with the big-name factor-based equity ETFs on the market. But few ETFs have hit the scene that focus on smart-beta bonds. And even fewer have attracted large asset flows.
According to ETFGI, $687 billion was invested globally in smart beta ETFs at the end of November 2017, but only a few billion was invested in smart beta fixed-income ETFs.
ETFs have proliferated because they are tax-efficient, liquid and transparent—and they cost less. Bond ETFs provide higher liquidity access to a complex and less liquid market, so they have slowly started to replace directly purchased bonds and other products in some fixed-income strategies.
Aggregate bond indexes such as the Bloomberg Barclays U.S. Aggregate Bond Index (“the Agg”) are often criticized as poor choices for bond investors because they concentrate in U.S. Treasurys and mortgage-backed securities, which are large but not very high-yielding segments of the bond universe.
“Indexes like the Agg have a few fundamental flaws, like lopsided distribution from a yield perspective,” says Gene Tannuzzo, a senior portfolio manager at Columbia Threadneedle and the firm’s head of strategic income. “They force investors into heavy exposures to government debt with low and unattractive yields and create artificial distortions in credit quality due to the way they weight corporate bonds.”
The benchmark bond indexes also tend to decline in diversity over time and are dominated by the largest companies by debt capitalization, meaning the corporate bond segment of the Agg places the most weight in the most indebted companies.
Return Drivers
Smart beta works differently in fixed income because the lion’s share of bond returns is determined by two factors—duration and credit risk—that are negatively correlated to each other.
“Basically, where you select to be on the yield curve becomes your primary driver of return, and after that the amount of allocation that you assign to credit will also drive returns,” says Mark Carlson, a senior investment strategist at Northern Trust’s FlexShares ETF business. Credit risk is intrinsically tied to value and quality in bonds—and more value is often found in corporate bonds of declining credit quality.
Yet some smart beta-like strategies, such as the ones that reweight indexes, may enhance the performance of fixed-income portfolios as well as equity portfolios, says James Meyers, director of fixed-income product strategy and research at Invesco PowerShares.