Alex Bryan, Morningstar Research Services LLC

Strategic-beta fixed-income funds attempt to deliver better performance than traditional market-capitalization-weighted index funds, or a specific outcome like a constant duration. These strategies often seem more intuitively appealing than the alternative of owning a broad market-cap weighted portfolio that tilts toward the biggest debtors. But these are active strategies, and they won’t all work.

Here are some questions we believe advisors and their clients should consider before including a strategic-beta bond fund in a portfolio.

6 questions to ask when evaluating strategic-beta bond funds

1. 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.
2. What factors does the fund target? Strategic-beta fixed-income funds are diverse, but most attempt to achieve higher returns and/or lower risk than their starting universe. 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 rationale, but they tend to pull in opposite directions on the credit risk spectrum, so many funds use them together. 
3. What metrics does the fund use to select its holdings? There are tradeoffs with any selection metric. While one set of metrics isn’t necessarily better than another, it’s important to understand those tradeoffs. Regardless of the metrics the fund uses, they should be:
   • Simple
   • Transparent
   • Clearly representative of the targeted investment style
4. How aggressively does the fund pursue its targeted factors? Funds that pursue their factor tilts more aggressively have greater active risk: more room to both outperform and underperform. Funds can often strengthen their factor tilts by setting more demanding thresholds for inclusion and incorporating factor characteristics into their weighting approach. However, departing from market-value weighting can increase transaction costs and make the fund’s index more difficult to track because most alternative weighting approaches overweight smaller and more thinly-traded issues.
5. What portfolio constraints are in place, if any? While they tend to moderate the strength of a fund’s factor tilts, constraints on a portfolio are usually prudent because they often limit risk and improve diversification. Without them, a fund may be susceptible to unintended bets and poorly compensated risks. Constraints can help prevent a value strategy from becoming too aggressive, or a quality fund from being overly conservative. The most common constraints include limits on:
   • Turnover
   • Tracking error to the starting universe
   • Duration
   • Credit risk
   • Sector exposure
6. How much credit and interest rate risk does the fund take? There’s a good chance that funds that regularly deliver market-beating returns are taking greater risk than the market. While credit and interest rate risk can sometimes pay off over the long term, they don’t always. And it’s important to keep in mind that credit risk is positively correlated with equity risk, so funds that take greater credit risk may be less effective at diversifying equity risk. 

Look under the hood of strategic-beta bond funds

Funds that claim to target bonds with similar characteristics may look and perform very differently from one another. It’s important to understand the risks that each fund takes and be comfortable with those risks. There are no free lunches in the bond world; funds that consistently deliver market-beating returns almost certainly take greater risk. Risk is not necessarily bad. What’s important is that the fund is deliberate about the types of risks it takes, that it delivers its intended exposures in a cost-efficient manner, and that its approach to portfolio construction is grounded in sound economic rationale.  

Please see below for important disclosure. 

Important Disclosure

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