Traditional broad, market-cap-weighted bond index funds have a lot going for them. They harness the market’s collective wisdom, charge low fees, tend to have low transaction costs, and don’t face key-person risk.
But the idea of assigning larger weightings to larger debtors isn’t intuitively appealing. In some cases, this approach, together with differences in how the opportunity set is defined, has made these bond indexes a low hurdle for active managers. For example, this market-cap weighting gives broad investment-grade bond benchmarks heavy exposure to low-yielding Treasuries and agency debt.
Strategic-beta fixed-income funds are index-based strategies that attempt to combine the best of active and passive. Most of these attempt to deliver better performance than traditional bond indexes in a more cost-efficient, transparent, and systematic manner than actively managed alternatives.
But they face some challenges. Limited data availability has led to slower product development and adoption of strategic-beta bond funds than among stock funds. And it isn’t always clear that strategic-beta funds offer differentiated exposure.
Credit- and interest-rate risk are the biggest drivers of bond returns, and many of these funds just repackage these risks, which may be available more cheaply through traditional cap-weighted index funds.
Morningstar recently published a report outlining the landscape of strategic-beta bond funds and a framework for evaluating their approaches to portfolio construction. The framework consists of the following questions, which investors should ask before buying any strategic-beta bond fund.
What is the fund’s investment universe?
The starting universe is the opportunity set from which the fund builds its portfolio. This provides a rough idea of a strategy’s riskiness and potential role in a portfolio. It can also be a useful performance benchmark for the fund.
What factors does the fund target?
While credit- and interest-rate risk are the most important drivers of bond returns, most strategic-beta funds don’t explicitly target high-risk bonds to dial up returns. Instead, the two most common approaches are to target bonds that are cheap and/or high quality. Both approaches have sound economic rationales, but they tend to pull in opposite directions on the credit-risk spectrum, so many funds use them together.
What metrics does the fund use to select its holdings?
There are trade-offs with any selection metric. While one set of metrics isn’t necessarily better than another, it is important to understand those trade-offs. For example, a fund can use accounting data, like changes in profit margins and leverage, to assess quality, or it could accomplish that task with market data, like credit spreads. Accounting data isolates particular dimensions of quality that might be predictive of default risk, but it is also backward-looking and could be stale.
In contrast, market data is forward-looking and quicker to detect changing fundamentals. However, the market doesn’t always get things right, and in some cases this approach can limit the section universe, particularly for funds that rely on equity market data.
Regardless of the metrics the fund uses, they should be:
- Clearly representative of the targeted investment style
In part 2 of this article, we will go through the other 3 questions to ask before buying a strategic-beta bond ETF.