Smart Beta Bond ETFs Hiding In Plain Sight

May 25, 2017

[This article appears in our June 2017 issue of ETF Report.]

One of the lingering questions about the smart-beta space is when—if ever—smart-beta bond ETFs will take off.

For years, smart-beta fixed-income funds have seemed just on the cusp of breaking big. But they’ve yet to truly blow up with investors—at least, not like smart-beta equity ETFs have. Bond ETFs still comprise only the tiniest tip of the smart-beta iceberg, with just $10.7 billion in assets under management, compared with $658 billion for smart-beta ETFs as a whole. In other words, fixed-income funds comprise less than 2% of total smart-beta assets.

Maybe, though, we’re asking the wrong question of smart-beta bond ETFs. Perhaps we shouldn’t ask when these funds will explode, but whether we’d even recognize it if they do.

What’s In A Name?
That’s because what constitutes “smart beta” has become exceedingly difficult to define, particularly in the fixed-income space, where active strategies have long dominated the conversation.

Are liquidity screens “smart beta”? What about hedging overlays, or selecting for credit events? When is an index “smart beta” enough?

For the purposes of this article, we’ve assigned the label “smart beta” to any fixed-income ETF that uses a nonmarket-value-weighted index—nearly the same definition we use for smart-beta equity ETFs.

That casts a rather wide net that ropes in some of the bigger nonvanilla fixed-income ETFs, like the PowerShares Emerging Markets Sovereign Debt Portfolio (PCY) and the FlexShares iBoxx 3 Year Target Duration TIPS Index Fund (TDTT), while excluding some funds that might otherwise make the cut, such as the two “fallen angel” ETFs, the VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL) and the iShares Fallen Angels USD Bond ETF (FALN); or preferred securities ETFs, like the Global X Super-Income Preferred ETF (SPFF).

Many of the ETFs that fall into our definition, however, aren’t actively marketed as smart beta by their issuers. In fact, often, investors don’t seem to be aware that their favorite fixed-income ETFs could earn the label.

“When I was researching different inflation-protection strategies we could use in our portfolios, it didn’t even occur to me that TDTT could be considered smart beta,” said Brian Presti, managing director of Investment Research for Concord, New Hampshire-based Harvest Capital Management. “In retrospect, of course, it makes sense.”

The invisibility of smart-beta bond ETFs may even be working to issuers’ advantage, since investors traditionally have looked to fixed income for safety and stability, whereas the label “smart beta” has come to suggest a certain level of riskiness. Plus, active management is still incredibly popular in fixed income; so a nontraditional bond index just won’t attract attention in the same way it would in the equity space.

Unseen Growth Spurt
While we weren’t looking, smart-beta bond ETFs had a growth spurt.

Since our last deep dive on smart-beta bond ETFs a year and a half ago (“Can Smart Beta Bond ETFs Gain Traction?”, January 2016), 11 new smart-beta bond ETFs have launched. Only three have closed—one because it was a target-date fund.

There now exist 40 bond ETFs we’d classify as “smart beta”—which is, overall, a miniscule number, but one that indicates increasing issuer interest. Figure 1 includes the largest of these funds.

Moreover, 11 of these 40 ETFs—or just over a quarter—now have assets above $100 million, a key liquidity metric for many advisors. Eight (20%) have assets above $100 million and daily average volumes exceeding $1 million. Smart-beta equity ETFs, in contrast, took years to achieve that level of investor buy-in.

Interestingly, the top smart-beta bond ETFs share a few key characteristics, potentially foreshadowing which strategies may continue to gain steam.

Investors Want Precision
When it comes to mitigating interest rate risk, investors want a scalpel, not a cudgel. Target duration funds, like the aforementioned TDTT and its sister fund, the FlexShares iBoxx 5 Year Target Duration TIPS Index Fund (TDTF), have accrued significant assets. (Duration is a measure of a bond’s interest rate sensitivity.)

“TDTT allows us to remove duration noise from our portfolios, so at any time, we know what our duration is,” said Presti. “It’s the combination of duration precision with inflation management that we specifically like.”

Another popular strategy: ETFs that use short Treasury positions to hedge out interest rate risk from their exposures, such as the ProShares Investment Grade-Interest Rate Hedged ETF (IGHG) and the ProShares High Yield-Interest Rate Hedged ETF (HYHG).

A Nonpartisan Approach To Risky Sectors
In riskier segments of the fixed-income market—such as high yield or emerging market debt—equal-weighting strategies have gained traction, as investors seek to avoid making too strong a bet in any one issue or country.

Two good examples include the equal-weighted PCY, which is one of the largest emerging market debt funds, smart beta or no; and the PowerShares Global Short Term High Yield Bond Portfolio (PGHY), which tracks high-yield debt in developing and emerging markets.

Factor Investing
Just as in the equity space, factor investing is a popular nonvanilla alternative in fixed income. The PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB), for example, weights junk bonds according to issuer financial data. The IQ Enhanced Core Plus Bond US ETF (AGGP), meanwhile, is a fund-of-funds that allocates to sectors with higher momentum.

Quasi-Active Strategies
Several smart-beta bond ETFs take their cues from active strategies. The WisdomTree Barclays Yield Enhanced U.S. Aggregate Bond Fund (AGGY), for example, uses a sector rotation strategy to optimize yield, while the PowerShares 1-30 Laddered Treasury Portfolio (PLW) applies equal weighting to a bond ladder. The Vident Core U.S. Bond Strategy ETF (VBND), meanwhile, applies a multifactor strategy to the broad market, based on sector tail risk, valuations and corporate governance.

Smart Beta’s Future In Bonds Not Guaranteed
Whether investors cotton to the presence of smart-beta bond ETFs probably has less to do with branding and more to do with where the bond market goes next. 

With rates back on the rise, funds that hedge interest rate risk are sure to do well. (Indeed, TDTT and TDTF have dominated net flows into smart-beta bond ETFs since the start of the year.)

At the same time, tightening credit spreads could dissuade some investors from entire swaths of the bond market, including corporate debt—smart beta or no.

Gary Stringer, president and CIO of Stringer Asset Management, is one such investor. His firm used to hold the PowerShares Fundamental Investment Grade Corporate Bond ETF (PFIG), but it sold it in 2016. Currently, it owns no smart-beta bond funds.

“We focus heavily on relative value in fixed income,” he said. “So we’ll likely buy [PFIG] back eventually … when it becomes more attractive from a risk/reward standpoint.”

Instead of alternative strategy, Stringer and Presti both point to nontraditional fixed-income sectors as a source of value. Stringer likes convertible bonds, nonagency MBSs and preferreds. Presti likes consumer credit and reinsurance.

One thing’s clear, says Presti: “You’re just not going to get value out of AGG anymore.”



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