Why Smart Beta Has Not Proliferated in the Fixed Income Space

Smart beta investing – a strategy that attempts to capitalize on market inefficiencies using alternative indexes – has expanded since the onset of the financial crisis, with recent data showing a faster uptake in the last few years. Assets invested in smart beta ETFs reached a new record high of U.S. $559.78 billion at the end of February, according to research firm ETFGI. At the time, 89% of smart beta assets were invested in the 606 exchange-traded funds and exchange-traded products (ETPs) domiciled and listed in the U.S.

Equity ETFs continue to account for the lion’s share of the smart beta market. As of 2016, only 3% of the 800 smart beta ETFs were fixed income funds. That’s fewer than 25 strategies, with a combined value of less than $18 billion. Clearly, there’s a large discrepancy between equity and fixed income smart beta strategies.

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There are at least four underlying reasons why fixed income assets have yet to make inroads into smart beta strategies.

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Liquidity Constraints

Fixed income strategies have struggled to succeed in the bond market due to underlying liquidity constraints, which have discouraged alternative weighting strategies in fixed income ETFs. However, all hope is not lost. While smart beta bond ETFs are less likely to displace vanilla-type funds, they are more likely to prevail over actively managed ones.

The iShares JP Morgan USD Emerging Markets Bond ETF (EMB A-) is one of the top smart beta fixed income ETFs with exposure to the bond market. FlexShares iBoxx 3 Year Target Duration TIPS Index Fund (TDTT B) is another strong candidate. The fund, which relies on a proprietary weighting scheme, aims for a weighted average portfolio of three years.

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Lack of Data

A lack of historical data and academic research have also made it difficult to validate the performance of smart beta fixed income strategies. In particular, the absence of this data has made it almost impossible to validate the factors that lead to outperformance in the fixed income space.

In this environment, it makes sense to develop a targeted approach to fixed income investing. Duration targeting with ETFs that are focused on interest rate risk and not credit risk is one such approach. The aforementioned FlexShares iBoxx 3 Year Target Duration TIPS Index Fund (TDTT B) and the FlexShares iBoxx 5 Year Target Duration TIPS Index Fund (TDTF B) are the most popular for portfolios targeting duration.

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Transaction Costs

High transaction costs routinely inhibit investment strategies from proliferating, especially in low-yielding environments. Transaction costs to buy and sell individual bonds are magnified in a market that lacks outperformance. This makes it even costlier for investors to create and redeem ETF units.

Investors looking to cut down on costs may choose to focus on ETFs with the lowest expense ratios. PowerShares 1-30 Laddered Treasury Portfolio ETF (PLW C+) and ProShares Investment Grade-interest Rate Hedged ETF (IGHG B-) are two such examples.

Increased Complexity

For many investors, the bond market is simply too complicated for smart beta strategies. Bonds are all about interest rates, curves and credit spreads, which add layers of complexity that ETF issuers have been slow to recognize in developing fixed income smart beta strategies.

One way to weed out complexity is to focus on ETFs with a fundamental weighting. The PowerShares Fundamental High Yield Corporate Bond Portfolio (PHB B) and the Vident Core U.S. Bond Strategy ETF (VBND B) are examples of these. Unlike traditional bond funds, which are weighed on the market value of debt issuances, these ETFs weight their holds on fundamental factors, such as book value and cash flows.

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Although smart beta has historically been equity-focused, the fixed income space will likely see a gradual influx of these strategies as demand for factor investing expands. As it turns out, there are some great parallels with bringing factors from the equity space into the fixed income space. Momentum is a perfect example of a strategy that has been well documented in equities but also works in fixed income and other assets.

It’s also important to mention that smart beta continues to make inroads in the fixed income space. WisdomTree Canada recently launched two new smart beta fixed income ETFs on the Toronto Stock Exchange. As smart beta undergoes further innovation, new factor models will be developed to overcome existing challenges in the fixed- income space. As it currently stands, fixed income products that are GDP- or fundamentally-weighted have been the most popular from a smart beta perspective. As the industry evolves, there’s little reason to believe further innovations won’t abound.

At the same time, it’s important to recognize the challenges fixed income faces in adopting smart beta strategies. Individual bonds remain expensive to trade, so liquidity continues to be an underlying issue preventing further expansion in smart beta strategies. Investing in fragmented markets is another major challenge associated with fixed income investing. The level of expertise required to successfully deliver factor exposure via a smart beta strategy is unlikely to change anytime soon.

While smart beta has yet to proliferate in the fixed income space, there’s reason to believe its implementation in this market will improve in the future. Until then, smart beta remains largely equity-focused.

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