What Is Smart Beta In Fixed Income ETFs?

May 26, 2017

Smart-beta and factor-based investing have swept the equity landscape, with investors big and small talking about ways to approach their portfolios from a factor perspective. What about bonds?

IndexIQ Chief Investment Officer Sal Bruno will tackle this topic at the forthcoming Inside Smart Beta conference, taking place June 8-9 in New York City. Inside ETFs CEO Matt Hougan sat down with Bruno recently to figure out how and if smart beta can work in a fixed-income framework.

Matthew Hougan, CEO, Inside ETFs: Smart beta has historically been an equity-focused phenomenon. What are the factors that drive performance in the fixed-income space, and why do they drive performance?

Sal Bruno, IndexIQ Chief Investment Officer: There are some great parallels with bringing factors from the equity world into the fixed-income world. Take something like momentum. Momentum has worked for 25 to 30 years in equities, and is well-documented, but it turns out it’s also worked in currencies, commodities and fixed income.

There are some challenges in fixed income that you need to accommodate. For instance, individual bonds are expensive to trade, so liquidity becomes a more important issue than it is in equities. So maybe you don’t apply momentum to individual bonds, but you instead look at sectors, which you can proxy with more liquid instruments like ETFs.

The same thing is true when you think about a factor like low volatility. High-yield bonds tend to be similar in a lot of way to equities. People tend to overweight some of the highest-risk names … leaving some of the lower-volatility names undervalued.

Again, there are some challenges: [You have to figure out how to] evaluate volatility in individual bonds. But once you do, you can think about it in very much the same way you do in the equity world.

Hougan: When you say there are challenges in evaluating the volatility of individual bonds, what do you mean?

Bruno: For equities, you can just use the percentage change on a daily basis and take the standard deviation, and that’s your volatility. But because bonds don’t trade every day, you can have gaps in those sequences. Also, you have some nonstationary characteristics in bonds such as the maturity and duration are changing through time for the same bond.

[That makes it] a little bit more difficult. The volatility profile of that individual bond is changing through time, so you need to think a little bit more carefully. Maybe you look at some other market-implied metrics to calculate what constitutes volatility for bonds at the individual level.

Hougan: But once you do, you see the same pattern of outperformance for lower-volatility securities in bonds as you do in equities?

Bruno: You do. People bid up high beta in the equity world and higher-yielding bonds in the high-yield space. They overpay for those … and that leaves some better values to be had in the lower-volatility names.

 

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