Smart Beta Fixed Income ETFs

Better than their Benchmarks?

April 2020. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Factor investing in fixed income has been heralded as the next frontier in asset management
  • Smart beta fixed income ETFs in the US manage only slightly more than $2 billion of assets
  • Defensive strategies reduced drawdowns during the ongoing coronavirus crisis

INTRODUCTION

Investing is becoming more scientific over time as technology continues to advance, but it will never be a hard science like physics. Take factor investing for example. Academic research, powered by ever-growing sets of data and better analytical tools, has shown that excess returns are explained by factors like Value or Momentum.

However, if a scientist starts querying on how these factors, e.g. Value, are defined, matters become complicated. The most common definition in academic research for determining the valuation of a stock is the price-to-book ratio. In contrast, cheap stocks are more likely measured by PE, EV/EBITDA, or cashflow multiples in practitioners’ research and actual investment products. Furthermore, these metrics can be combined, measured over various time periods, rebalanced frequently or infrequently, overall highlighting a high level of discretion and subjectivity.

In this context, it is interesting to highlight that factor investing is far more popular in equities than fixed income, despite the latter being a much more mathematical and perhaps scientific discipline. Investors have allocated more than $800 billion to smart beta equity ETFs in the US, compared with only approximately $2 billion to equivalent vehicles in fixed income.

The bulk of research focuses on factors in the global equity market, but papers like “Investing with Style” and “Value and Momentum Everywhere” from Cliff Asness and his colleagues at AQR have laid the theoretical foundation for factor investing in fixed income. In fact, AQR has heralded fixed income as the next frontier in factor investing in 2016.

In this short research note, we will explore the performance and characteristics of smart beta fixed income ETFs in the US.

DEFINING THE SMART BETA FIXED INCOME ETF UNIVERSE

Indices can be differentiated between providing exposure to plain, different, and smart beta. Plain beta represents the well-kno