Parish: Waiting For Smart-Beta Bond ETFs

June 03, 2014

In all the hoopla about ‘smart beta,’ bond funds have largely been left out—for now.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by Anthony Parish, vice president of Research & Portfolio Strategy at Austin, Texas-based Sage Advisory Services.

The global stock market is about one-third the size of the global bond market, but there are nearly four equity ETFs for every fixed-income ETF—1,030 versus 273, respectively, according to data compiled by ETF.com Analytics.

That imbalance is even greater when it comes to smart-beta ETFs. In the equity world, this category has mushroomed in the past few years, but in the bond world, it is still just a tiny backwater.

We’ll get into the reasons for this in a moment and into how we think this dearth of innovation can’t last, but first let’s establish a working definition of the term “smart beta.”

While a passive index fund attempts to efficiently replicate a clearly defined market segment, a smart-beta fund attempts to enhance investors’ experience by applying rules that alter the weighting of securities in that segment.

This may be accomplished by rebalancing a given market index through the application of fundamental risk factors or through a simple mathematical application such as equal weighting. The result should be better returns, lower volatility, better diversification or some combination of benefits.

Second, we’re generally skeptical that the results of most smart-beta funds can live up to their hype. In our view, this investment category includes lots of creative applications chasing hot fund flows. We suspect time will show there’s a lot more sizzle than steak, though a small group of funds may rise above the rest.

Cap-Weighted Indexes

Smart-beta sprang from the desire to improve the weighting methodologies used in traditional market indexes. It highlights a shortcoming of the cap-weighting methodology; namely, the inevitable favoring of the largest companies, which some could argue are the most overvalued.

Cap weighting is different in the stock world and bond world, however.

For stocks, a cap-weighted index favors the largest companies by market capitalization, as was the case for the telecom companies before the tech crash in 2000, and for the banks just before the financial crisis of 2008.

For bonds, cap-weighting an index favors the issuers that have the largest amount of debt outstanding.

This is an important distinction. Overweighting the largest companies often reduces risk (relative to smaller companies), while overweighting the most heavily indebted companies actually increases it.

Given that the typical bond investor is more risk-averse than the typical stock investor, the cap-weighting methodology seems more ill-suited to the bond world. And yet it is the de facto standard for the more popular bond indexes.

 

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