FIXED INCOME: Badly in need of work

Derelict_houseFixed income is the natural next stage for the smart beta revolution. A low-yield bond market has provided an added incentive, says Catherine Lafferty.

Smart beta, the factor-based investment revolution, is now well in its second wave. The first wave of the revolution saw smart beta strategies sweep the equities board. Very liquid and transparent, equities, always the first asset class to use trackers and passive products, proved particularly amenable to smart beta strategies.

Fixed income seems like the natural next stage for the revolution to take and in addition, a low-yield bond market has provided an added incentive for fund managers to adopt a smart beta approach.

Indeed, given the current macroeconomic environment, and forecasts of a prolonged period of rising interest rates, many investors are seeking more diversified and factor-aware approaches to fixed income investing.

But challenges specific to fixed income have meant that, so far, progress in the uptake of smart beta in fixed income in the UK has been slow. Fund managers are clear as to the reason for this: one of the challenges with traditional indices is that they are market-cap weighted and this does not work for fixed income as it does for equities.

Deborah Fuhr, managing partner of ETFGI, says: “There are just a handful of smart beta ETFs at the moment. One of the issues is that no one has come up with good smart beta bond indices yet and you cannot design products without indices.”

Persuasive case
However, aficionados of smart beta in fixed income contend that there is a persuasive case to be made against the market-cap weighting model in fixed income investing.

They point out that, since almost all bond indices are issuance weighted, governments or companies which issue more debt thereby gain a bigger position in the index and hence in the portfolios of index-benchmarked investors. A propensity towards issued debt, they note, does not necessarily result in better returns.

Indeed, leaving traditionally weighted benchmarks behind increases fund managers’ control of their policy objectives. Neither a passive nor an active approach fits perfectly with fixed income investment goals and exposure to a credit or term premium can be built into portfolios. Alternatively weighted smart beta strategies provide a controlled means of applying a fund manager’s views on market segments such as specific factors like value, quality and low volatility.

Manuela Sperandeo, iShares regional head of specialist sales in London, says: “In the current macro environment, it is becoming more challenging for fixed income investors to generate long-term attractive returns. This in turn is driving investors to question traditional ways they have accessed the bond markets and explore new types of bond indices. Traditional bond cap-weighted indices have the potential to be impacted by diversification, liquidity and transparency. Put simply, they are more likely to have a higher allocation to more indebted issuers and potentially overvalued bonds.”

Market ineptitude can be propelled by structural inefficiencies and investor behaviour in both fixed income and equities alike. Just as investors shy away from leverage and move to riskier equities in pursuit of high returns, resulting in the overbuying of higher volatility stocks, leverage-averse bond investors may see longer-duration bonds as overpriced on a risk-adjustment basis compared with shorter maturity bonds.

There are inefficiencies that are particular to bond markets and have long been factored into fund managers’ strategies. Proponents of fixed income smart beta funds say they try to grasp these inefficiencies equitably and transparently.

Sperandeo says: “The basic premise of smart beta and factor investing applies to bonds: it is about identifying drivers of risk and return in order to meet specific outcomes.”

She adds: “There are two main types of factors in fixed income markets. One is duration risk; and credit spreads the other. The importance of these two factors is dependent on the relative size in potential changes in interest rates versus changes in spreads for different types of bonds.

“For example, credit spreads are more important for high yield, whereas duration factors are of greater importance for investment grade bonds as they have lower credit spreads.”

Relatively new in fixed income, there are smart beta products in corporate bonds and government bonds.

Ben Seager-Scott, chief investment strategist at BestInvest Tilney, says, “Fixed income is an area badly in need of smart beta work. As it is a complicated beast, it takes longer to produce these products but I expect to see them in the next few years.”

Early adopters in the UK so far include Lombard Odier and ETF Securities. These firms have a tie up producing smart beta fixed income.

Lombard Odier’s range of smart beta fundamental fixed income ETFs takes into account what it considers the most relevant factors in order to target a better balance of risk and return. For government debt indices, these are GDP, budget deficits, social imbalances and political stability. For corporate debt it looks at the contribution to GDP of the different corporate sectors.

A range of exposures are available in European corporate bonds, European government bonds, global corporate bonds, global government bonds and in emerging market bonds. Deutsche Bank has also established a substantial range of strategic beta ETFs, now numbering more than 20, in the past few years. It offers factor exposures as well as more straightforward strategic beta exposures, such as dividend-weighted and equal-weighted equity ETFs.

Martin Weithofer, head of strategic beta at Deutsche Asset Management, says: “In the coming years, we expect to see more investors adopt long-term buy-and-hold positions in equity factors, as well as using equity factor exposures for tactical, semi-active trading. We are working with clients at the moment to provide them with a quantitative factor assessment framework, which is a tool that helps clients take a view on which factors may be likely to outperform.”

A variety of bond sectors are available. Deutsche Asset Management has ETFs that provide quality-weighted exposure to eurozone sovereign bonds and to emerging markets sovereign bonds. It also has a number of ‘yield plus’ sovereign bond ETFs which aim to provide a higher yield than standard sovereign bond indices while still controlling for risk. In an ongoing low-yield environment, these have been very popular. There is, in addition, a yield plus ETF providing exposure to euro-denominated corporate bonds.

“This is perhaps one of the most interesting parts of the market for investors at the moment, as it provides an attractive risk-return profile for investment-grade types of investors,” Weithofer says.

A number of investment factors or betas found within bond market behaviour constitute a ’smart beta’ or ‘investment factor’. Weithofer adds: “We have clearly identified quality as an investment factor that can be singled out in the bond market, which is why we have two quality-weighted bond ETFs as part of our product offering. This is because it is relatively straightforward to take a number of fundamental indicators on the quality of the credit and create a methodology that produces a quality-weighted index.

“For example, for sovereign bonds you can look at the economic fundamentals of the countries issuing the bonds, such as GDP growth, national reserves as a percentage of GDP, and so on. Our quality-weighted bond ETFs work on this basis, and investors are starting to appreciate the benefits.”

Thus far, factor investing has mainly been an equity phenomenon. It is yet to be widely explored and adopted by fixed income investors. But, the inefficiency in benchmark bond indices and the relative lack of transparency in pricing means there is ample opportunity in the future.

Fund managers who use smart beta approaches in fixed income are confident that it is a successful investment strategy.

“We believe that factor-based fixed income strategies will grow in popularity among investors, which will in turn lead to a growth in the number of products,” BlackRock’s Sperandeo says.

“The demands of investors today are in line with what smart beta and factor investment strategies offer. They want solutions that aim to deliver clear investment objectives, including better diversification, improved risk-versus-return profiles and precision exposure to specific fixed income factors.

“This could lead to new products coming to the market in order to reduce exposure to rising rates, have a greater weighting to countries with a more favourable risk return and screening credits based on quality.”

©2017 funds europe