Smart Beta In Fixed Income ETFs Slowly Takes Root

It’s not unusual to hear that fixed income is the next great frontier for smart-beta ETF product development. The stats would suggest there’s plenty of room for growth. They also show that finding success in this segment remains a challenge, even if innovation continues to break through.

Consider that we are ending 2016 with nearly 800 smart-beta ETFs on the market—or almost half of all U.S.-listed ETFs—but only 3% of them are fixed-income funds. That’s fewer than 25 strategies, with combined assets of less than $18 billion, according to our count.

Smart beta in fixed income typically means bypassing traditional market-value selection and weighting schemes for alternatives that seek to hone in on key drivers of bond performance, such as duration, rate and coupon.

Smart-Beta Opportunity In Bonds

Perhaps one of the biggest challenges for ETFs to succeed in this segment is tied to opportunity. Unlike in the equity space, smart-beta bond ETFs aren’t really displacing vanilla-type funds, but are more likely to displace actively managed ones. And in bonds, active management has a pretty good following. We’ve written about this before.

Liquidity constraints, transaction costs, spotty data for individual bonds and a lack of academic research are also all barriers in this segment, serving to discourage alternative weighting schemes in fixed-income ETFs.

There’s also the issue of performance. Outperforming a vanilla take on a market segment isn’t what smart beta sets out to do. But lack of outperformance for what’s often a higher price tag can be an issue preventing some of these funds from attracting investor interest.

Top 3 Smart-Beta Fixed-Income ETFs By Assets

A look at the top three smart-beta fixed-income ETFs shows that moving away from market-value selection and weighting doesn’t always equate with outsized gains.

Here are the top three ETFs at a glance:

iShares JP Morgan USD Emerging Markets Bond ETF (EMB), $7.9 billion in AUM

EMB tracks an index of U.S.-dollar-denominated emerging market sovereign debt. The bonds must have more than $1 billion outstanding and at least two years remaining in maturity. The strategy implements a tiered weighting methodology, which, according to the fund’s prospectus, “is designed to distribute the weight of each country within the Underlying Index by limiting the weights of countries with higher debt outstanding and reallocating this excess to countries with lower debt outstanding.”

The fund tends to favor longer maturities than a segment benchmark such as the market-value-weighted Barclays EM Local Currency Government Index, and also “tends to lean toward riskier paper, both of which increase yield,” according to ETF.com Analytics.

PowerShares Emerging Markets Sovereign Debt Portfolio (PCY), $3.8 billion in AUM

PCY is another dollar-denominated emerging market bond fund holding debt with at least three years to maturity. The fund employs a tiered weighting scheme in a portfolio that also takes into account liquidity and relative value.

Both EMB and PCY have underperformed a traditional vanilla take on the segment this year, such as the Vanguard Emerging Markets Government Bond Index Fund (VWOB). Note that EMB costs a net of 0.40% after a 0.20% fee waiver, while PCY charges a 0.50% expense ratio. VWOB is the cheapest, at 0.34%: 

FlexShares iBoxx 3 Year Target Duration TIPS Index Fund (TDTT), $1.8 billion in AUM

TDTT tracks an index of inflation-protected U.S. government debt with maturity of anywhere from 1-10 years. The fund uses a proprietary weighting scheme, and strives for weighted average portfolio duration of three years, which means shorter maturity and duration than a comparable segment benchmark such as the Bloomberg Barclays 1-10 Year U.S. Government Inflation-Linked Bond Index. TDTT also tends to have lower nominal yield, according to ETF.com Analytics.

Compared with SPDR Bloomberg Barclays 1-10 Year TIPS ETF (TIPX), which selects and weights bonds by market value, TDTT has also underperformed in 2016. TDTT is also the most costly to own, with a net expense ratio of 0.20% versus 0.15% for TIPX. 

Charts courtesy of StockCharts.com

New And Novel

Despite the challenges to growth, there are exciting new flavors of smart beta popping up in fixed-income ETFs.

Among the 30 or so fixed-income ETFs that came to market this year, there have been a few interesting new takes worth mentioning. A pair of IndexIQ funds launched last May, the IQ Enhanced Core Bond U.S. ETF (AGGE) and the IQ Enhanced Core Plus Bond U.S. ETF (AGGP), come to mind.

The strategies are among the first to apply momentum factor to fixed income in a multifactor weighting scheme that ultimately looks to provide higher allocation to fixed-income classes that show higher momentum.

Both AGGE and AGGP are fund of funds offering wide ranging exposure in terms maturity, region, as well as investment grade and high yield.

And for two ETFs that are only seven months old, AGGP today has $211 million in assets while AGGE is hovering at $80 million.

These two funds are just a glimpse into the potential for innovation in this segment—something many expect to see going forward, particularly as issuers respond to investor demand for new approaches to fixed-income investing in a new era of rising rates.

For a complete list of ETF launches, detailing all fixed-income ETF newcomers, check out our ETF Watch. And for a comprehensive list of smart-beta ETFs, see our smart-beta ETFs channel.

Cinthia Murphy at [email protected]