Bold Strategic Beta In Bond Land

So-called strategic beta funds have become ubiquitous in the ETF landscape. They’ve now captured more than 26% of equity ETF assets in the U.S.

Fixed income has lagged behind. “Smart” or strategic indexing commands a mere 1.5% of bond ETF assets. Vanilla funds have a full 94% of the U.S. ETF fixed-income investor dollars. Nearly all of today’s strategic bond funds target a single factor: either duration or credit.

Vident and iShares are hoping to capture investors’ imaginations with new multifactor strategic-beta bond funds. They’ve brought three complex strategies to market over the past 12 months. Tellingly, these funds aim to deliver risk-adjusted outperformance.

A deep dive into the hidden world of strategic fixed income will make clear just how bold Vident’s and iShares’ moves have been.

The Lay Of The Land
Innovation within the fixed-income ETF landscape has been historically limited to a few segments, mostly involved with U.S. corporate debt and complex government obligations such as TIPS. The focus has largely been on risk control—either on duration management or on improving credit profiles. Most of the strategic-bond beta dollars are in the duration-focused funds, so we’ll look at those first.

Two types of strategies offer investors a way to change their interest-rate risk profile: duration targeting; and interest rate hedging. These funds vary in three key ways: the core index exposure; the hedging strategy; and the target duration. You can see your choices in Figure 1.

Duration Targeting & Hedging
The most popular of the bunch, the $2 billion FlexShares iBoxx 3-Year Target Duration TIPS (TDTT | A-48), aims to tame TIPS’ interest-rate risk by employing a variable weighting scheme to keep portfolio duration right around three years, regardless of market conditions. TDTT offers a useful tool to investors who understand that TIPS duration risk could limit their effectiveness as an inflation hedge.

The duration-hedged funds haven’t fared as well as TDTT, at least not so far. When rates turn, these funds will be waiting, offering opportunities to capture credit premia in a rising rate environment.

The flagship fund, the ProShares Investment Grade Interest Rate Hedged (IGHG | C), is typical of the group. IGHG offers exposure to U.S. dollar-based corporate credits, with an overlay of short Treasurys. Financial engineering has created a portfolio with a long average maturity—nearly 15 years, as of November 2014—but virtually no interest-rate risk. If rates rise steeply, IGHG could well offer attractive returns that offset its hedging costs.

The Price Of Duration Control
Controlling interest rates has a cost. Target-duration funds must rebalance portfolios to keep durations within a specified range. TDTT rebalances monthly. Because the Markit iBoxx Target Duration TIPS indexes reduce their value every month to account for trading costs, our usual method of comparing a fund’s returns with those of its underlying index obscures the true cost of rebalancing.

Investors should keep in mind that target-duration funds must trade every month. While the TIPS market is quite liquid, the MBS market underlying the FlexShares Disciplined Duration MBS (MBSD | D) is not. Worse, mortgage-backed securities tend to overreact to interest-rate hikes, so rebalances stand to increase in severity just at the moment when duration control is most needed. In other words, MBSD could cost investors extra in a volatile market.

Duration hedging has a cost, too. Although trading in U.S. Treasurys and Treasury futures is nearly frictionless, short positions have holding costs. The short side of the trade pays the interest. This means hedgers don’t capture the full yield of their core portfolio.

Instead, they earn the spread between Treasurys and their core index. Worse, they’re on the hook for any price changes in their short position. In the 12 months through March 20, 2015, the WisdomTree Barclays US Aggregate Bond Zero Duration (AGZD | B-41) lost 0.25%, while the unhedged Barclays US Aggregate Index gained 6.03%. Ouch!

Vanilla Interest-Rate-Risk Control
Luckily, there’s a third way to control duration risk. Both Guggenheim and iShares offer so-called bullet maturity bond funds. These funds hold bonds that mature within a 12-month window. With terminal values known, investors can largely ignore market volatility, barring default. There’s no guarantee of purchasing power protection with these funds, and investors will face reinvestment risk—the need to put a big slug of cash to work all at once.

Bullet maturity funds aren’t really strategic beta, per se. They screen by maturity, and by investment grade, but that’s it. They use the entire opportunity set, in tiny tranches, at market-value weights.

There’s no free lunch in duration control. As always, investors need to weigh the costs and risks, and decide what risks they’re willing to bear, and what price they’re willing to pay to offload the unwanted risks.

Playing With Credit Quality
The second major source of risk and return in fixed income is exposure to credit. A dozen strategic bond funds offer ways to adjust a portfolio’s credit profile. Some of these funds do their own credit research, while others use credit agency ratings to select or weight securities. The choices are listed in Figure 2.

Like the new multifactor strategic bond ETFs, RAFI’s fundamental indexes advertise “improved risk-adjusted returns,” by avoiding the so-called bums problem, by which the biggest debtors have the heaviest weights.

The largest credit-focused strategic beta bond fund, the PowerShares Fundamental High Yield Corporate Bond (PHB | C-75) aims to scale holdings by their firms’ debt service capacities. PHB’s portfolio is indeed higher quality than its vanilla competitors.  Higher quality, as usual, means lower yields, as you can see in Figure 3.

As always, it’s important to understand these alternative credit funds’ returns in light of their risks. When methodologies isolate higher-level credits, portfolio risk should decline. These funds should provide some level of protection when defaults pick up, but lag when credit spreads tighten. That’s exactly what we’ve seen with PHB. Three- and five-year performance has suffered because of this, as credit has rallied substantially.

Most investors in the target-rating funds, which are dominated by the single-year-maturity iShares suite, are probably invested in these funds for an entirely different reason: duration control. iShares offers three such suites: in munis; corporates; and corporates ex-financials.

Not many folks realize the ex-financials funds track indexes with a fundamental bent. These indexes split constituents into two groups by credit rating, and then weight each group such that the overall index has an average credit rating of A (or A2, in the Moody’s system). Despite their vanilla labels, these funds have a strategic weighting scheme.

Multifactor Bond ETFs: Magical Or Mundane?
So far, we’ve looked at funds that target one type of risk only, either interest rate or credit. Over the past year, iShares and Vident have introduced multifactor funds; that is, funds that turn both risk/return dials at once.

It’s much too soon to tell if any of these funds has delivered risk-adjusted outperformance. The oldest multifactor fixed-income ETF reached its first birthday in April. Investors will have to wait a while to see what these funds’ complex methodologies deliver.

What’s clear now is that these funds are not vanilla.

Technically, the brand-new iShares Yield Optimized Bond (BYLD | D-48) is designed to deliver higher yields, but equal risk to that of the Barclays U.S. Aggregate Index.  It’s been delivering on the higher-yield part, offering a 2.58 yield-to-maturity versus 2.04 for its bogey, the iShares Core US Aggregate Bond (AGG | A-98) (as of Nov. 28, 2014).

BYLD clocked in with a duration of 4.04, weighted average credit of BB+ and 2.58% yield. Its bogey was both more and less risky, with a higher duration (5.23) and a higher average credit rating (A+), but a lower yield of 2.04%. Is BYLD riskier than AGG? It’s different, that’s for sure.

The Vident Core US Bond Strategy (VBND) is different, too. Like BYLD, it includes high-yield bonds and promotes diversification among the sectors of the U.S. bond market. Its duration and weighted average credit lies between that of BYLD and AGG, but its 1.93% yield didn’t pack much of a punch.

The iShares US Fixed Income Balanced Risk (INC) is actively managed, according to the Securities and Exchange Commission. INC is entirely rules-based, but BlackRock needed to designate it as “active” because it uses futures, which aren’t allowed under BlackRock’s exemptive relief permit.

The Future Of Strategic Fixed-Income ETFs 

Most likely, investors in strategic fixed-income ETFs will discover what their counterparts in equity strategic beta have found; that is, they will have an altered risk profile, with commensurately altered returns. Put another way, equity strategic beta has not delivered risk-adjusted returns, so it’s probably fair to say that alpha-via-strategic beta bond funds face a high hurdle.

For those not looking for a free lunch, strategic bond ETFs can be excellent tools to adjust interest-rate risk or credit risk. It’s useful to be able to select precise exposures, taking wanted risks and shucking unwanted ones.

As long as the financial engineering is cost-effective, strategic-beta bond funds offer everyday investors increasingly precise tools. As always, make sure you read the manual before opening the toolbox.