Most Popular Smart Beta Fixed Income ETFs

"Smart beta" has taken the ETF industry by storm. There are now 771 exchange-traded funds listed in the ETF.com smart-beta channel, or four out of every 10 ETFs on the market. There's even a whole conference dedicated to smart-beta ETFs taking place next month (it will be hosted by Inside ETFs in New York on Sept. 22-23).

The ETF.com channel uses the broadest definition of smart beta to decide whether a product fits that category. That is, "any index-based strategy that either chooses securities or weights securities for an intentional reason other than their market capitalization, geography or sector classification."

When it comes to equity ETFs, there are plenty of products that can be considered to fit the smart-beta bill. From factor-based strategies rooted in academic research to more questionable strategies that straddle the line between passive and active, smart beta has truly blossomed in the equity space, with more than $500 billion in assets under management.

The same can't be said for fixed income. In fact, there's only 23 smart-beta fixed-income ETFs on the market, a small fraction of the 315 total fixed-income ETFs available to trade. Together, these funds have a relatively modest $9 billion in assets.

Smart-Beta Challenges

There may be a number of reasons for the lack of growth in smart beta in the fixed-income space. Liquidity constraints, transaction costs, spotty data for individual bonds and a lack of academic research all serve to discourage alternative weighting schemes in fixed-income ETFs.

Nevertheless, even with these challenges, a few ETFs have gone on to become successful by offering investors a different take on the traditional market-value-weighted fixed-income products that dominate the landscape.

Fundamental Weighting

The PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB), with $1 billion in assets, and the Vident Core U.S. Bond Strategy ETF (VBND), with $470 million in AUM, are examples of these.

Unlike traditional bond indexes and ETFs that weight their holdings based on the market value of debt issuances (with the most indebted issuers getting the largest weighting), PHB and VBND weight their holdings based on fundamental factors.

PHB looks at the book value and cash flows of an issuing firm when weighting its U.S. high-yield corporate bonds. The fund also excludes the lowest-rated junk issuances below a B rating.

The higher credit quality of PHB's portfolio results in a lower yield. The current 30-day SEC yield for the fund is 4.14%, less than the 5.63% yield for the iShares iBoxx $ High Yield Corporate Bond ETF (HYG). Its effective duration of four years is slightly higher than HYG's 3.9 years.

Long term, the fund has underperformed, with a gain of 29.4% since inception, compared with 60.3% for HYG (from November 2007 through Aug. 16, a period that encompasses the financial crisis).

Returns For PHB & HYG Since Nov. 2007

Meanwhile, VBND uses a multifactor approach to get exposure to the broad U.S. bond market. The ETF "overweights sectors with favorable valuation and momentum" based on a rules-based model.

VBND's 30-day SEC yield at 2.3% is a tad lower than the 2.5% for the market-value-weighted iShares Core Total USD Bond Market ETF (IUSB). VBND has also underperformed IUSB since its October 2014 inception, returning 5.5% versus 7.4%.

Another fund worth mentioning is the PowerShares Emerging Markets Sovereign Debt Portfolio (PCY), with $3.8 billion in assets. PCY equally-weights each country in its portfolio, while using liquidity and value screens to select which individual bond issues to hold. The fund directly competes with another dollar-denominated EM bond fund, the vanilla iShares JP Morgan USD Emerging Markets Bond ETF (EMB). 

PCY currently has a 30-day SEC yield of 4.77%, higher than the 4.28% for EMB. PCY has also outperformed its rival since the latter's inception on Dec. 2007, with a gain of 91% versus 78%.

Momentum-Based Fund Of Funds

PHB and VBND are two of the largest fundamental-weighted bond ETFs, but they're not the only ones. WisdomTree has a whole suite of such ETFs targeting different areas of the bond market.

There's also a new ETF from IndexIQ launched this year that has attracted a lot of attention. The IQ Enhanced Core Plus Bond U.S. ETF (AGGP), launched in May, already has $218 million in assets.

AGGP weights its holdings based on price momentum. However, its holdings aren't individual bonds, but rather other bond ETFs.

AGGP is essentially a fund of funds that uses ETFs to get its exposure to the broad spectrum of fixed-income securities, from Treasurys to mortgage-backed securities to corporate bonds to dollar-denominated emerging market bonds.

The fund has a yield of around 2.5%, comparable to the aforementioned IUSB.

Returns For AGGP & IUSB Since May 10

Targeting Duration

A third group of fixed-income products worth mentioning are those that target a specific duration for their portfolio. These ETFs are more concerned with interest rate risk and not credit risk or yield like many of the other smart-beta fixed-income products.

The FlexShares iBoxx 3 Year Target Duration TIPS Index Fund (TDTT) and the FlexShares iBoxx 5 Year Target Duration TIPS Index Fund (TDTF) are the most popular of these, with more than $2.4 billion in combined assets.

TDTT and TDTF hold U.S. government-issued Treasury inflation-protected securities of various maturities to hit a particular modified adjusted duration target. For TDTT, it's three years; for TDTF, it's five years.

Duration is a measure of a bond's sensitivity to interest rate changes (the higher the duration, the greater the interest rate sensitivity). Thus, TDTT and TDTF are designed to keep interest rate risk constant, which may be appealing to some investors.

Contact Sumit Roy at [email protected].