Can Smart Beta Bond ETFs Gain Traction?

[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.

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.”

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.

The Hazy Future of Smart-Beta Bond ETFs
Some newer bond ETFs try to optimize both duration and creditworthiness at the same time. For example, the $413 million Vident Core U.S. Bond Strategy ETF (VBND | C) selects and weights U.S. bonds by sector tail risk, security valuation and corporate governance.

But it remains to be seen whether these combo funds, or any smart-beta bond ETFs, will catch on with investors.

A persistent lack of liquidity may be preventing wider use of smart-beta bond ETFs, says Ladner, whose firm has used PHB in the past. “Liquidity is a large concern for us,” he said. “An ETF must have a certain asset size and trading volume before we can even consider it, and there aren’t a lot of fixed-income smart-beta ETFs that pass that test right now. Plus, the market makers really aren’t on board yet for these alternative weighting schemes.”

It’s the classic chicken-or-the-egg scenario: Smart-beta bond ETFs need a wider presence to catch on with investors, but they can’t gain that presence without investors first using them. And that’s stymying growth: No new smart-beta bond ETFs were filed or launched in 2015, although in February, iShares did introduce a “technically active” bond ETF, the U.S. Fixed Income Balanced Risk ETF (INC | C).

Still, the potential is there. Convincing investors may simply require more research, says Ladner.

“If you don’t have any expectation about how something will perform, it’s very difficult to use it in a portfolio setting,” he said.