Smart-beta funds have soared in popularity over the past decade.
According to Statista, 59% of U.S. investment managers have 11% or more of their assets under management in smart-beta strategies, and only 3% don’t use them at all. These strategies are especially valuable in fixed income, where rising interest rates could cause chaos.
Let’s look at some challenges facing fixed-income funds and how smart-beta factors could offer a solution.
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What Is Smart-Beta?
Many conventional index funds are weighted by market capitalization, meaning that individual stocks with higher market capitalizations represent a more significant part of the fund. As a result, a handful of large companies tend to represent an outsized portion of the index’s total value, skewing the exposure some investors seek.
Smart-beta strategies leverage certain performance factors to enhance and outperform an index. While they go beyond copying an index, no fund manager picks individual stocks or sectors. These dynamics place it between an actively managed and a passively managed fund with an expense ratio reflecting that point.
There are many different ‘factors’ that smart-beta funds use. For example, equities use value, size, momentum, quality, and low volatility. On the other hand, fixed income tends to focus on value, momentum, and quality. Of course, the difference between quality and value and whether low-vol is a component of quality depends on the fund manager.
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Challenges in Fixed Income
The problems associated with conventional index funds are even worse in fixed income.
Similar to stocks, the biggest issuers of bonds tend to represent the most considerable portion of an index. The problem is that while market capitalization is a sign of strength, bond issuance is a sign of indebtedness. And investors end up owning the most indebted firms.
In today’s uncertain interest rate environment, it’s also increasingly challenging to balance quality and yield. Investors in high-yield bond funds must ensure that the quality is there to avoid defaults, particularly in the corporate sector. Unfortunately, high-yield bond indexes don’t account for quality in their selection process, making these trade-offs challenging to measure.
According to the S&P SPIVA Scorecards, active managers in fixed income have primarily failed to beat popular benchmarks despite these challenges. The only areas where active managers outperformed passive indexes in 2020 were investment-grade intermediate funds, short government funds, and investment-grade short funds.
How Factors Improve Returns
The fixed-income markets are a bit more complex than equities since there are multiple goals. For example, some investors may be looking to maximize their yield-to-maturity (YTM), whereas others may want to minimize risk or produce income ladders. As a result, the right smart-beta strategy depends mainly on the investor’s goals.
FactorResearch compared the yield-to-maturity across smart-beta fixed-income funds and arrived at some unique insights:
- Total U.S. Bond Market: The YTM of multi-factor ETFs was significantly higher than the benchmark due to more prominent exposure to higher-yielding industrial and financial issuers.
- U.S. Corporate Bonds: The YTM of multi-factor ETFs was lower than the benchmark because of a tilt toward cheap bonds and a minor tilt to quality bonds.
- U.S. High Yield Bonds: Value factor ETFs tended to generate a higher yield, while quality and low volatility ETFs held less risky bonds that provided investors with a lower yield.
When factoring in risk, value, and momentum strategies tended to outperform benchmarks over time, while quality and low volatility strategies offered better risk-adjusted returns and less severe drawdowns during a crisis like the COVID-19-related plunge. Thus, investors must balance these risk and reward characteristics when selecting methods.
Finally, remember that smart-beta funds tend to have higher expense ratios than index funds. These fees cut into returns over the long term and should be a part of any decision to buy or sell a fund.
The Bottom Line
Smart-beta funds have become increasingly popular over the past decade and comprise a significant portion of institutional portfolios. In fixed income, these funds can play a vital role in enhancing risk-adjusted returns by factoring in quality, value, momentum, and low volatility rather than just investing in the most indebted issuers.
Don’t forget to check our Fixed Income Channel to learn more about generating recurring income in the current economic environment.
