Adding Smart Beta Fixed Income ETFs To Your Portfolio

August 31, 2016

This article is part of a regular series on thought leadership from some of the more influential ETF strategists in the money management industry. Today's article is by Andrew Gogerty, vice president of investment strategies at Boston-based Newfound Research LLC.

According to Google Trends, interest in smart beta has been on a steady climb since late 2012. Leveraging this interest, ETF manufacturers have accelerated production of all types of smart-beta solutions.

Where, exactly, the line is drawn that defines a new product as smart beta or not is still fuzzy, but the broad common trend so far has been that the vast majority of these new products has been focused on equities.

This makes sense, as equities are—for most investors—the main driver of both long-term capital growth and risk within their portfolio, and therefore garner the most attention. Yet recent evidence suggests that fixed-income exposure could also benefit from pragmatic, well-thought-out smart-beta processes to portfolio construction.

The traditional market-capitalization-weighted process for constructing equity indexes has the side effect of increasing allocations to those securities that have relatively outperformed their peers.

Traditional Fixed-Income Weighting

In fixed income, the equivalent process is issuance-weighting, whereby the country, government agency or company that issues the most debt receives the largest weight. While bond credit ratings and relative yield can compensate an investor for the relative risk of companies to make good on their debts, the recent past has shown this is not always the case.

In addition, large, broad-based indexes such as the Barclays Aggregate Bond Index have become less diversified over time, and now are dominated by U.S. government and agency debt. Not only does this represent a decrease in internal diversification, but with interest rates near all-time lows, the return outlook for government and agency debt is muted.

With these considerations in mind, we wanted to highlight some interesting smart-beta fixed-income ETF exposures, how they introduce unique exposures and how they might be used in a portfolio.

Fixed-Income ETFs

An interesting starting point is the VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL). This ETF takes advantage of the structural disconnect in the institutional fixed-income market. When there is a downgrade from investment-grade to high-yield status, this inevitably means managers with mandates permitting only investment-grade bonds will have to indiscriminately liquidate the downgraded bond.

So while these “fallen angel” bonds have the potential to be intrinsically higher quality than debt originally issued at the junk or high-yield level, undue structural selling pressure from the downgrade can cause them to sell at a discount.

Given that market structure isn’t likely to change anytime soon, the ETF’s ability to take advantage of this potential temporary mispricing can add value over time. Thus far, in lower-rate environments, the ETF tilts toward value and quality exposures have produced a relative outperformance compared with broader high-yield offerings.

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