2 Strategic Beta Bond ETFs That Are Worth a Look

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Should investors bite on strategic beta ETFs? Joining me to discuss some research on that topic is Alex Bryan. He is director of passive strategies research for Morningstar in North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, let's start by talking about the baseline market-cap-weighted bond index funds. In a lot of respects, they have been a pretty easy mark for active bond managers to beat. Why has that been the case?

Bryan: A lot of traditional bond indexes basically offer broad exposure to the market and then they weight their holdings based on market value, which means that they tend to tilt toward the more heavily indebted issuers. Now, in the U.S. investment-grade market that means that you get a lot of exposure to U.S. Treasuries which tend to be high quality, but they also offer very low yields. You also get a lot of exposure to agency mortgage-backed securities which have that same type of high-quality low-yield type of characteristics.

As a result of that those benchmarks have been easy to beat because a lot of active managers will just take a bit more credit risk and all of a sudden, they are able to earn a nice yield pickup. Indexes are a good starting point, but a lot of times, managers are able to take more credit risk to beat them.

Benz: There are these so-called strategic beta ETFs, exchange-traded funds. Let's talk about what they are and how they attempt to take a different approach to indexing than just buying the cap-weighted index.

Bryan: Strategic beta funds are essentially trying to offer a performance advantage over traditional bond indexes. Most of them try to do that by targeting bonds that either have attractive value characteristics--and in the bond world that often comes back to yield--or attractive quality characteristics. Value and quality tend to pull you on opposite directions on the credit risk spectrum. A lot of funds actually use these two characteristics together--quality to try to mitigate risk and value to try to find some yield pickup with the bonds that are remaining.

Benz: This is a relatively new subset of funds. Let's talk about some of the challenges that they face in trying to beat those core bond benchmarks.

Bryan: There's three challenges. Number one, data availability is very limited in the bond world. A lot of good bond price data doesn't go back farther than 2000, and that makes it very difficult to do a lot of back-testing or to do out-of-sample testing to figure out if these models that look good in sample would work out of sample.

Benz: Nevermind that the funds haven't been around that long. We just don't even have data that corroborates whether they are good strategies that goes back that far?

Bryan: Exactly. It's really easy to build a model that works really well in sample, but the key test here is whether or not it's going to work going forward. One way we can get confidence around that is if you take some data that's out of the sample that was used to create that model and see if it still works. There just isn't a lot of data out there to allow you to do that. That's the first challenge.

The second challenge is that in the bond world risk and return are very, very closely linked. A lot of times when you find a higher returning bond, chances are that it's just compensation for credit risk or interest-rate risk. It isn't clear that some of these new factors like value and quality do much more than just repackage these traditional risk exposures. You might be able to get that exposure more cheaply through traditional bond indexes, for example, by overweighting investment-grade corporates.

The third challenge that we have is liquidity. One of the benefits of weighting your holdings based on market value is you tend to lean into the largest bond issues in the market. Those tend to be the easiest to obtain and the cheapest to trade. When you deviate away from market cap weighting, you essentially dip into less liquid securities, and that can make the index a little bit harder to track. It can also increase transaction costs. Funds that are coming to market have to grapple with these three challenges.

Benz: For investors who are compelled by this idea of being in a strategic beta bond ETF, what are some of the key factors they should keep in mind when evaluating a fund?

Bryan: There's really six key questions you need to ask yourself as you are going through the due diligence process for evaluating the bond fund's process. Number one, you have to understand what the starting universe is that acts as your performance benchmark for the fund. It also gives you a sense of how risky the fund is likely to be.

Number two, you need to understand what factors the fund is targeting. Because there is a trade-off between, like I mentioned, value and quality. Typically, if you have a quality-oriented strategy, a lot of times you will weed out some of the riskier issuers from the universe which can provide some good downside protection, but it may also cost you some yield on the upside.

Number three, it's important to understand how the fund is going about measuring those factors. Because there's trade-offs with any metric that you use. For example, I can measure quality using accounting metrics like financial leverage, or I could use market data to assess quality based on how wide those spreads are. There's trade-offs with each. Accounting data can be stale. The market may react to things that aren't necessarily directly related to quality. There's always trade-offs, and it's important to understand what those are.

It's also important to understand how much risk the fund takes, how actively or how aggressively it's going after these targeted factors. The more aggressive you are with your bond selection--if you have a higher threshold for inclusion--that means that you are deviating from the benchmark more which increases your chance of outperformance, but it also increases your risk of underperformance. It's really important to be comfortable with those risks that you are getting.

It's also important to take a look at whether or not there's any constraints on the risk that you are taking in the fund. That's really important with any type of fund that's trying to go after value or yield. If you don't constrain the portfolio, if you don't limit the types of risks it can take, you may end up with more risk than you bargain for. You need to make sure that you are comfortable with that.

Finally, look back at those traditional risk metrics--credit and interest rate--and make sure that you are comfortable with those risks. Because a lot of times juicy yields really come from dialing up those two risk levers. It's really important to pay attention to risk and also pay attention to the fees that you are paying for the fund.

Benz: As sort of a more broad point, it rarely makes sense to bite on a totally untested product, right? You want to see a little bit of a track record in addition to understanding all of the strategic factors you just talked about?

Bryan: That's right. It's not just to look at whether or not the fund has performed well. You want to understand, OK, has this fund performed the way that I would expect it to. If I'm looking at a quality-oriented fund, did it tend to hold up better than a broad market-cap-weighted benchmark during market downturns; is it providing the type of exposure that I would have expected it to; is it tracking its index well? Those are the things that are more important than did it beat the index over this period. You really want to see is it conforming to your expectations.

Benz: There are a couple of strategic beta bond funds that you and the team like. Let's talk about them and why you think that they are actually worth a look.

Bryan: One of the funds that we like within the investment-grade corporate bond space is the iShares Edge Investment Grade Enhanced Bond ETF, ticker is IGEB. What this fund does, it combines quality and value, basically filters out the 20% of issuers from the market that have the highest probability of default, according to BlackRock's proprietary model. Then it leans into value with the remaining bonds in the universe. Basically, it's trying to maximize its default adjusted spread. It's trying to adjust for the risk of default and then go after the bonds in the markets that have the highest spread relative to their default risk. I like this because in pursuing these value characteristics it's trying to constrain the risk that it takes, both through the quality filters that it has in place, but also it has some additional constraints to limit how much interest-rate risk it can take or how much credit risk it can take. I think it keeps risk in check, but still gives you a nice yield pickup and doesn't take too much risk on the low end of the credit spectrum.

Benz: Do funds like this typically have any constraints on the percentage of their portfolios they can put in a single issuer? Would that be part of the strategy?

Bryan: Yes. They typically do. Usually, individual issuer weightings are very, very low, typically under 3%.

Benz: The second fund that you like in this strategic beta bond space?

Bryan: Another fund that I like is the WisdomTree Yield Enhanced U.S. Aggregate Bond ETF. This is a fund that we rate Bronze. This is a yield-oriented fund. In other words, it has a bit of a value focus, but it basically starts with the Bloomberg Barclays U.S. Aggregate Bond Index. It divides that index into 20 subcomponents. Its's looking at different sectors of the bond market within the investment-grade space, and it reweighs those components of the Ag in order to maximize yields subject to some constraints to rein in risk.

What you effectively end up getting is you end up getting a bit more credit risk than you would with the traditional Barclays Aggregate Bond Index, but you get a nice yield pickup. In my opinion, I think the Bloomberg Barclays Aggregate Bond Index is a bit more conservative than a lot of investors are used to getting with a lot of their active bond managers in the investment-grade space. I think this is a really good fund if you are looking for a replacement for an active bond manager who you suspect might just be taking more credit risk to boost returns. You can get that yield pickup with this fund for a low 12 basis points fee.

Benz: That's a very low expense ratio. That's good to hear. Alex, interesting topic. Thank you so much for being here to discuss it with us.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.