Can Smart Beta Bond ETFs Gain Traction?

January 04, 2016

The 2 Flavors of Smart-Beta Bond ETFs
Currently, smart-beta bond ETFs slice the fixed-income market along the two main vectors that determine bond returns: interest-rate sensitivity, and credit risk.

“You really only have these two levers to play with,” said Kashner.

Most smart-beta bond ETFs today opt to tackle interest-rate risk, which is described by a statistic known as duration.

Smart-beta strategists can reduce a portfolio’s interest-rate risk by a) engineering a low effective duration through careful selection of securities for the index; and/or b) hedging out risk using short positions in Treasurys and/or Treasury futures.

The first tactic is used in the market’s most popular smart-beta bond ETF, the $1.9 billion FlexShares iBoxx 3-Year Target Duration TIPS ETF (TDTT | B-48). TDTT selects from and weights TIPS with maturities between one and 10 years, such that the fund’s overall duration of 3.0 years doesn’t waver.

The $144 million ProShares Investment Grade Interest Rate Hedged ETF (IGHG | C), meanwhile, overlays a short Treasury position on top of investment-grade corporate debt to hedge out interest-rate risk.

If and when interest rates rise—which experts have been predicting for some time—ETFs like TDTT and IGHG should perform very well. But they’re not without downsides.

Target-duration funds must frequently rebalance their portfolios to keep duration constant; TDTT, for example, rebalances monthly. That’s easy enough to pull off for liquid securities like TIPS, but harder for less liquid ones, like municipal bonds.

“Because of high portfolio turnover, greater due diligence is warranted in understanding both the liquidity and index tracking risk for these funds,” said Kashner.

Hedging has its drawbacks, too. Maintaining short Treasury and Treasury futures positions also means paying the holding costs, as well as shouldering any price changes in the position. This can wither away returns.

An alternative smart-beta bond ETF strategy is to control the portfolio’s overall credit risk. This is done by screening securities by credit ratings, such as those from Moody’s or Standard & Poor’s. Securities are often then weighted by fundamental financial metrics, like book value and cash flow.

The $659 million PowerShares Fundamental High Yield Corporate Bond ETF (PHB | C-78) does exactly that, tracking a fundamentally weighted index of debt rated between Ba1/BB+ and B3/B-.

The big downside, of course, is that the higher a bond’s credit quality, the lower its yield tends to be. Plus, high-quality bonds offer protection in case of default but can trail when credit rallies.

Still, optimizing creditworthiness is an approach that appeals to Stringer, who uses the PowerShares Fundamental Investment Grade Corporate Bond ETF (PFIG | C-76) for his clients.

“We actually feel more comfortable with PFIG than we do with something like the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD | A-77), because we think there’s more risk in LQD’s underlying [bonds] than for PFIG,” he said.

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