Fundamental Bond ETFs

Fundamental, or “smart-beta,” indexing has helped spawn many stock exchange traded funds that steer away from the traditional market-capitalization methodology. However, enhanced indexing styles haven’t gotten the same traction in the fixed-income category.

There are only four enhanced bond index-based ETFs, with $724 million in assets under management, reports Carolyn Cui for the Wall Street Journal. The PowerShares Fundamental High Yield Corporate Bond ETF (NYSEArca: PHB) alone accounts for $653 million in assets. [How ‘Smart-Beta’ ETFs Fit in a Portfolio]

To put this in perspective, there are 333 enhanced index ETFs, with $136.0 billion in assets under management, according to XTF. [Jaffe Weighs in on Schwab Fundamental ETFs]

Bond ETFs that follow fundamental weights have underperformed traditional market-cap weighted options. The shortfall may be attributed to higher quality bonds – firms with lower credit ratings issue higher yields. Investors have favored riskier bets in an attempt to generate higher yields.

Fundamental bond indices shift away from traditional indexing methodologies that weight based on debt outstanding, which some argue would tilt toward heavily indebted companies or countries and expose investors to greater credit risk. For instance, the PowerShares PHB ETF utilizes a Research Affiliates RAFI index that weights bonds according to companies’ book value, sales, dividends and cash flow.

“You end up with a tilt toward companies with strong fundamentals and greater ability to make payments on their debt,” Shane Shepherd, head of fixed-income research at Research Affiliates, said in the article.

PHB has a 0.50% expense ratio, a 4.39 year effective duration and a 4.35% 30-day SEC yield. The fund is up 0.5% year-to-date.