Strategically Balanced: iShares’ New ETF

Depending on your definition of “smart” or “strategic” beta, iShares U.S. Fixed Income Balanced Risk ETF (INC) may not be iShares’ first strategic beta bond ETF, even though it came to market with that billing.

This honor might go to INC’s direct segment competitor—the iShares Yield Optimized Bond ETF (BYLD | D-48). Still, INC is the first iShares ETF that aims to systematically provide controlled exposure to the two fundamental risk/return factors in fixed-income investing: interest-rate risk; and credit risk.

Given all the anxieties surrounding the path of interest rates, INC is a much-welcomed innovation in the fixed-income space. In fact, judging by its seed capital of roughly $75 million, institutions are liking what they see.

Active, Yet Highly Methodical

Despite its active management classification, according to its regulatory filings, INC is actually highly transparent and methodical. It employs what I would consider a three-step model-driven and rules-based portfolio construction process to create a portfolio that carries roughly the same amount of interest-rate and credit risk.

Here’s how it works:

• Step 1: Historical research identifies and selects best risk-adjusted credit sectors. This step identifies the top five credit sectors with the best risk-return efficiency. The concept is similar to Sharpe ratio in which INC’s methodology calculates risk/return efficiency by dividing excess return by annualized standard deviation of the past 10 years.
• Step 2: Equally risk-weight each sector. Each sector receives respective weightings inversely proportional to their risk contributions to the overall portfolio in order to achieve equal risk contribution by sectors. In other words, less risky sectors (e.g., agency backed MBS) will receive larger weightings, while riskier sectors (e.g., high-yield bonds at the lower end of the rating scale) will receive smaller weightings. This step creates the backbone of the portfolio, which largely locks in its credit risk exposure with implicit duration-risk exposure underneath.
• Step 3: Adjust Treasury futures overlays to dial up and down portfolio interest-rate sensitivity. To achieve its 50/50 duration risk and credit-spread-risk composition, the portfolio uses (long or short) Treasury futures to adjust its duration.

The final portfolio should have roughly equal exposure to interest-rate sensitivity and changes in credit spreads. The idea here is that such equal exposure would provide better risk-adjusted returns than your typical market-value-weighted exposure—think the popular Barclays US Agg Bond Index—according to iShares.

Different Market Conditions

You might be tempted to dismiss INC as just another unnecessarily complex strategy that ultimately charges investors extra fees. But consider that INC costs only 25 basis points in expense ratio, which is the cheapest among any active bond ETFs.

Furthermore, once you take into account the possible performance outcomes in different rate and credit scenarios, INC’s thesis has merit since interest rates and credit spreads historically have shown zero-to-weak negative correlations.

The following table helps illustrate some of these possible outcomes:

Each box represents a different combination of interest-rate and credit-spread scenarios. In theory, INC should do very well in “Box 2” when both rates fall and spreads tighten, as it is getting performance from both underlying risk-free rates and credit exposure.

On the other hand, INC will not do well—much like any other long-only fixed-income instruments—in “Box 4” when it will get hit from both return drivers.

In the scenarios seen in boxes 1 and 3, INC should deliver some decent returns from one of the two drivers. In the end, it boils down to the magnitude of the changes in both risk components.

Intriguing Approach

I’m intrigued by INC’s unique take on the U.S. bond market, but I have to say I’m still unconvinced by its 50/50 target risk composition. I am not sure INC’s strategy will generate enough risk-adjusted outperformance to justify its price tag of 25 basis points when a typical vanilla U.S. aggregate fund charges less than half of that.

We are living in an unconventional monetary policy environment. It wouldn’t surprise me to see rising rates as well as widening of spreads—the “Box 4” scenario. In that case, there’s really nothing anyone can do to protect a long-only bond portfolio. Regardless of your view on the path of interest rates, one thing is clear: INC is a well-thought-out product that provides an innovative take on the two fundamental risk/return drivers in fixed-income investing.

It’s a too bit early to tell whether it will work, but holding all else equal, I might just have enter a very-early nomination for INC as ETF.com’s Best New Fixed Income ETF of 2015!

At the time this article was written, the author held no positions in the securities mentioned. Contact Howard Lee at [email protected].