A new crop of rules-based bond ETFs is attempting to improve on traditional market-cap-weighted alternatives.
A version of this article was published in the June 2016 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.
There's a lot to like about market-cap-weighted bond index funds. They offer low fees, a consistent and transparent approach with no key-manager risk, and low transaction costs because they favor the most-liquid issues and have fairly low turnover. But market-cap weighting may not be the optimal way to construct a bond portfolio because it tilts toward the most heavily indebted issuers. The implications of this are different in the investment-grade and high-yield market segments. In the investment-grade market, cap-weighting skews most portfolios toward low-yielding Treasuries and agency mortgage-backed securities, dragging down expected returns. In the high-yield market, the biggest debtors may have particularly high credit risk.
Several recently launched bond exchange-traded funds apply alternative screening and weighting approaches in an attempt to offer a better risk/reward profile than market-cap-weighted alternatives while retaining the benefits of traditional indexing. Each of these funds takes a distinctive approach and should be analyzed as an active strategy, even if it tracks an index. There are some promising candidates in this lineup, but they aren't all worthy of an investment.
The Barclays U.S. Aggregate Bond Index is a natural starting point for thinking about a core bond allocation, as it is built to represent the U.S. investment-grade bond market. Many active managers and ETFs tracking alternatively weighted indexes attempt to boost returns relative to the Aggregate Index by taking more credit risk. This isn't difficult, as Treasuries and agency MBS jointly represent over 60% of the index.
WisdomTree Barclays U.S. Aggregate Bond Enhanced Yield ETF AGGY accomplishes this by reweighting the constituents of the Aggregate Index. It divides the benchmark into 20 subcomponents based on maturity (short, medium, and long term), credit quality, and sector (government, corporate, and securitized). Each month it reweights the subcomponents to maximize yield, subject to a few constraints. These include limiting tracking error relative to the parent index to 35 basis points each month, capping its sector tilts and allocation to lower-credit-quality subcomponents at plus or minus 20 percentage points of their levels in the parent index, and limiting turnover. Additionally, the fund's duration cannot be more than a year greater than that of the parent index.
The end result is a modest pickup in yield relative to the Aggregate Index, greater exposure to lower-quality (A and Baa rated) debt, and slightly greater interest-rate risk. Overall, this fund is a compelling option for investors who want a little more return and are willing to take a little extra risk to get it--especially as it charges a very attractive 0.12% expense ratio.
IQ Enhanced Core Bond U.S. ETF (AGGE) (0.34% expense ratio) takes a more aggressive approach to boost returns. It applies a trend-following momentum strategy within five segments of the investment-grade bond market, including corporates, MBS, and short-, intermediate-, and long-term Treasuries. This is based on the well-documented tendency for recent performance to persist in the short term, which has been observed in every major asset class. A compelling explanation for this is that investors may under-react to new information, causing prices to adjust more slowly than they should. Once a trend is established, investors may extrapolate recent performance too far into the future and pile into the trade, further contributing to momentum.
While momentum has historically worked on paper, profiting from it in practice is a significant challenge because it requires high turnover. This is particularly true in the fixed-income market, where transaction costs tend to be far greater than in the equity market. To address this issue, AGGE is set up as an ETF of ETFs, which improves liquidity and reduces the number of required transactions.