Can Smart Beta Bond ETFs Gain Traction?

January 04, 2016

[This article originally appeared in our January issue of ETF Report.]

Smart-beta ETFs have colonized the equity space, netting $52 billion in asset inflows as of November 2015. That’s roughly 30% of all fresh assets into U.S. ETFs for the year.

In fixed income, however, smart beta barely blips the radar screen. Smart-beta bond ETFs accounted for just $4.5 billion, or 1.4%, of total assets in all fixed-income ETFs. As of Nov. 28, 2015, smart-beta bond ETFs had actually seen net outflows for the year—$20.3 million worth—though of course some individual funds had attracted more investor interest than others.

All this raises the question: Are smart-beta bond ETFs dead in the water before they can even land with investors?

How Do You Solve A Problem Like Bond Indexing?
In a way, the case for smart-beta bond ETFs writes itself, because the bond market doesn’t exactly make vanilla indexing easy.

“Benchmarking the bond market is much, much harder than it is for equities,” said Elisabeth Kashner, director of ETF research for FactSet.

That’s because the bond market is vast. Each individual company, country or municipality may issue dozens of bonds, and the marketplace boasts hundreds of thousands of issuers at any given moment. Globally, millions of securities exchange hands each day. As a result, few broad market bond funds even come close to replicating their benchmarks; the iShares Core U.S. Aggregate Bond ETF (AGG | A-98), for example, only holds 4,300 of the more than 9,600 securities in the Barclays U.S. Aggregate Bond Index.

Structural roadblocks further complicate matters. Bonds lack a single, centralized trading exchange with publicly available pricing; issues instead trade over-the-counter. Prices can vary wildly from dealer to dealer, while spreads often fluctuate by lot size.

“Liquidity will always be an issue in fixed income. That’s just the nature of the beast,” said Scott Ladner, managing director and head of quantitative and alternative strategies for Horizon Investments.

Confronted by this chaos, many bond indexers opt for the path of least resistance: making their benchmarks resemble equity indexes as much as possible.

Most bond indexes weight securities by market valuation, or issue size multiplied by price. But while this mimicry of market cap weighting may feel familiar to investors, it creates two significant problems.

First, market weighting means companies or countries with the most debt outstanding make up the largest percentages of the index. “Skewing toward issuers with a bigger debt load won’t necessarily work out well for you, especially in a shaky economic environment,” said Gary Stringer, president and CIO of Stringer Asset Management.

Second, indexes end up prioritizing higher-priced bonds over cheaper issues, regardless of their underlying creditworthiness. And when it comes to bonds, a higher price tag doesn’t always correspond with higher credit quality.

Smart Beta & Bonds

For a larger view, please click on the image above.

Together, these flaws mean that market-weighted bond indexes don’t reduce risk—they increase it. That’s counterintuitive for most investors, who typically look to fixed income to mitigate overall portfolio risk.

Where challenge exists, however, so too does opportunity. The failures of mainstream bond ETFs leave an opening for smart-beta strategies, said Ladner. “There’s a hole in that product space somebody ought to try to fill.”

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