Smart beta strategies have taken the equity markets by storm, with hundreds of ETFs launched and billions of dollars in assets flooding in. But as exciting as these strategies are, the best opportunities in smart beta may actually lie elsewhere in the wild world of fixed income.
The reason is simple: traditional fixed income indexes are dumb. In a traditional fixed income index, the weight of a security — therefore, the amount of money invested in a fixed income index fund — is directly related its debt. The higher the debt, the higher the weight.
This is obviously insane, and yet, it’s the foundation for a trillion-dollar industry.
In the run-up to our upcoming Inside Smart Beta conference, taking place June 8-9, I’ve been looking at some new approaches to applying smart-beta-style thinking to the fixed income universe. Here are three funds that caught my eye.
IQ S&P High Yield Low Volatility Bond ETF (HYLV)
I’m a big believer that the primary driver of smart beta returns is human behavior. Investors gravitate to high-flying stocks, for instance, leaving value stocks undervalued. Similarly, investors fall in love with well-researched big companies, leaving smalls caps room to grow. I recognize these behavioral biases in my own mind and therefore can easily imagine them in the broader world.
One of my favorite investor anomalies is our penchant for high volatility stocks. Academic studies show that investors love high vol stocks, whether due to the lottery effect or because they tend to be high-profile names. How often do you think about Apple (the largest stock in the world) versus Sandy Spring Bancorp (one of the smallest)?
Investors love these high flyers so much that they overvalue them and undervalue lower volatility names. Over time, investing in lower vol names can lead to higher returns, despite their lower risk. It’s a free lunch!
While this strategy has been very popular in the equity space through funds like the PowerShares S&P Low Volatility ETF (SPLV), IndexIQ’s new product is the first to apply it to fixed income. The firm notes that high-yield bonds operate much like stocks: higher vol names get all the attention. When you add in the fact that high-vol bonds tend to have the highest yields, you get even more overcrowding. That leaves lower risk/lower yielding names undervalued.
Investors buying into HYLV shouldn’t expect it to necessarily beat the broader high-yield market over time. The product is inherently lower yield and lower risk than the market as a whole and, therefore, has a lower beta to the market. But on a risk-adjusted basis, its common-sense approach should do well, freeing you up to take more risk in the rest of your portfolio.
WisdomTree Fudnamental U.S. Corporate Bond Fund (WFIG)
WFIG is a tiny ETF with just $5 million in assets under management, which means you should tread carefully if you choose to buy. Still, the fund and others in the WisdomTree fixed-income suite are worth considering, as they take a very common-sense approach to improving on corporate bond exposure — instead of just looking at how much debt different companies have, it actually looks at the ability of those companies to pay back the debt. Amazing right?
To build its portfolio, the fund will first do a basic screen of the U.S. corporate bond space, looking at each firm’s leverage ratio, free cash flow versus debt payment commitments and return on invested capital, screening out the worst 20 percent. It then weights the remaining universe based on probability of default, duration and yield. The end result should be a portfolio of solid companies that can actually pay their debts, all for an expense ratio of just 0.18 percent. Not bad, eh?
iShares Edge U.S. Fixed Income Balanced Risk ETF (FIBR)
While the ticker is reminiscent of dietary supplements, FIBR is a cool little fund offering a unique take on the smart beta fixed income space.
The core idea behind FIBR is that there are two big drivers of bond returns: duration and credit. Interestingly, studies show that those two drivers are negatively correlated — credit does well during economic boom times and duration tends to win during difficult times for the market when investors are fleeing to quality. FIBR’s approach is simple: keep an equal weight exposure to both factors and you’ll come out ahead.
The fund currently has $110 million in assets under management and charges 0.25 percent in fees. It offers a compelling alternative to traditional corporate bond ETFs, particularly for those investors worried about the impact of rising rates.
The research into smart beta in the fixed income space is still evolving and more work needs to be done on all of these funds. But with the return-challenges facing fixed income investors in today’s markets, now is the time to consider new strategies, and these products are among the most interesting out there.
You can join Matt Hougan and hundreds of leading smart beta thinkers at the forthcoming Inside Smart Beta conference, taking place June 8-9, 2017, in New York City. Click here to view the agenda and register.