Parish: Waiting For Smart-Beta Bond ETFs

June 03, 2014

Index Challenges

Compared to stock indexing, bond indexing is exponentially more challenging. That’s probably why equity ETFs were around for 13 years before the industry figured out how to bring the first fixed-income ETF to market.

For one, large issuers tend to have just one stock but many bonds. For instance, a quick Bloomberg search for IBM reveals the company has 38 distinct bond securities.

Also, there’s no centralized market for pricing bonds. Prices in the secondary market vary from dealer to dealer and are heavily influenced by the size of allocation. The larger the size, the tighter the bid/ask spread. However, even very large allocations tend to have wider spreads than equities of decent-sized companies.

On top of it all, the bond market is vast, making it virtually impossible for index funds to own all the securities in the index. A stock index fund like SPY holds all 500 names that are in the S&P 500. A bond index fund like the iShares Core Total U.S. Bond Market ETF (AGG | A-97) holds less than a third of the 8,000-9,000 securities in the Barclays Aggregate Bond Index.

As a result, fixed-income index funds must work with the bonds that happen to be available and liquid, and devise clever weighting methodologies to create a basket that mimics the index. They must make large assumptions about volatility, correlations, transaction costs and liquidity—four variables that change significantly from day to day and month to month.

As a result, fixed-income index funds are much less efficient than equity index funds, as measured by tracking error versus their stated benchmarks.

So Where Are The Bonds?

Having said all this, shouldn’t the same ingenuity that’s required to mimic a bond index lend itself to systematically enhanced indexing? You would think so, but the lack of “smart-beta” bond funds suggests otherwise.

There are a few “smart beta” bond funds on the market. For instance, there are the PowerShares fundamental-weighted funds:

  • PowerShares Fundamental Investment Grade Corporate Bond Portfolio (PFIG | B-75)
  • PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB | B-78)
  • PowerShares Fundamental Emerging Markets Local Debt Portfolio (PFEM | F-67)

All three use a similar approach to their fundamental stock-fund counterparts.

Then there’s the iShares Yield Optimized Bond ETF (BYLD), a new product with weightings determined by the yield and volatility characteristics of the securities in the portfolio.

After that, the list drops off pretty quickly.

Some may argue that a few duration-hedged funds or target-maturity funds should be included. Others may say some actively managed funds should be included, but we’re not convinced.

Regardless, the full list of enhanced-index fixed-income ETFs is pretty slim. Of the funds mentioned, only the fundamental high-yield fund PHB has gathered a critical mass of assets. The others are tiny.

We don’t believe that will last.

Inevitably, fixed-income ETF manufacturers will begin to shift their focus and innovate. The equity world is saturated. The global bond market offers $150 trillion of securities to work with. Interest rates around the world are at historic lows, and investors will undoubtedly reward ETF innovators who create smart efficient ways to optimize fixed-income performance.


Sage, an independent investment management firm, serves institutional and private clients with traditional fixed-income asset management and global tactical ETF strategies. Sage began using ETFs in 1998, and today offers a range of tactical all-ETF solutions, including income-focused and target-risk global allocation strategies. Contact Sage at 512-327-3330 or sageadvisory.com.

 

 

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