A Smart Beta Bond ETF for a Changing Fixed-Income Landscape

Fixed-income ETF investors should weigh the risks found in traditional market cap-weighted bond funds and consider alternative methodologies that could help better mitigate potential risks ahead.

On the recent webcast, Targeting Income in the New Rate Regime, Edward Kerschner, Chief Portfolio Strategist, Columbia Threadneedle Investments; Katherine Nuss, Director, Fixed-Income Product Management, Columbia Threadneedle Investments; Joe Mallen, Chief Investment Officer, Helios Quantitative Research; and Jay McAndrew, National Sales Manager, Strategic Beta, Columbia Threadneedle Investments, looked to an alternative way to source income and manage potential income volatility in this new rate regime.

Fixed-income investors face changing market conditions where they will have to better manage income and account for income volatility ahead. Specifically, many do not realize the risks associated with utilizing a cap-weighted bond benchmark as an investment vehicle since the traditional weighting methodology does not foster diversification, with high correlations among the various components. Alternatively, investors should consider a multi-sector bond strategy filtered for opportunity rather than indebtedness.

From the 1980s, the fixed-income market has enjoyed a prolonged bull run as yields on benchmark U.S. 10-year bonds declined from almost 15% to 2%. The policies of the past four decades helped push down yields and produced a prolonged bull market in bonds.

Since 2007, quantitative easing helped depress interest rates to unprecedented low levels. Central banks previously begun to bring monetary policy back to normal, but that move has been put on pause.

The strategists also underscored the risks associated with a growth budget deficit. U.S. tax reform offers potentially higher growth but increasing deficits. When budget deficits are large and the economy is expanding, tax cuts could have more of an effect on inflation than growth, which could put additional upward pressure on interest rates.

Despite the various rate risks that bond investors face today, many still remain fixated on benchmarking their portfolios to the Bloomberg Barclays US Aggregate Bond Index Market Value. The so-called Agg is now worth more than $22 trillion.

Many bond investors now face greater exposure to unintended concentration risks. The Agg held 22% of its index in U.S. Treasuries at the end of 2007, but the tilt toward U.S. Treasuries has increased to 39% today. When factoring in debt issued by government agencies and mortgage-backed securities, the total government exposure is now over 70%. Furthermore, the Agg index has historically exhibited high correlations among the top components, with the correlation of the top two components – U.S. Treasuries and MBS – at 83%, and the benchmark holds minimal exposure to components with low cross-correlations. Consequently, the Agg now exhibits a low risk-reward profile.

Bond investors, though, can look to alternative income sources to enhance yields and returns while potentially diminishing risk exposures. For example, the Agg does not include sector exposures like High Yield, Global Treasuries or Emerging Market debt, which have much lower cross-correlations to U.S. Government debt. Moving out along that risk-reward profile to include these alternative income source that could provide access to less correlated opportunities with relatively high returns.

For example, the Columbia Diversified Fixed Income Allocation ETF (NYSEArca: DIAL) follows an alternative indexing methodology to potentially help bond investors garner improved returns and potentially diminish the negative effects of sudden swings. DIAL is the top performer across 354 open-end mutual funds and ETFs in the Morningstar category US Multisector Bonds.

The bond ETF tries to reflect the performance of the Beta Advantage Multi-Sector Bond Index, a rules-based multi-sector strategic approach to debt market investing. The underlying smart beta index covers six sectors of the debt market. The result is an index customized for each sector, optimizing for yield, quality and liquidity with monthly rebalancing discipline to manage drift.

By achieving its goal of yield enhancement, DIAL includes multiple sectors throughout the US and around the globe; excludes short term government with limited yield; excludes non-government with limited risk premium; and exclude negative yielding bonds.

The ETF’s quality management aims to avoid the “tails of the market” by removing sectors that offer no risk premium and lower quality tiers that have outsized downside risk, which essentially means no corporates rated below single-B ratings, no sovereigns rated below double-B ratings and no corporates longer than 15 year maturity.

Additionally, the fund keeps in mind liquidity limitations or focuses on issues with sufficient tradability to provide investors with liquidity, managed against volatility. The index screens for larger issue size, screens for recently issued securities and limits number of bonds per issuer.

During the webcast, Joe Mallen, CIO of independent ETF strategist firm Helios Quantitative, said their research showed fixed income is an area where active management can outperform in the long-term.

“We do a scoring system internally that looks at things not just like returns, but capture, adjustments, and looking at tracking error relative to benchmarks we’re seeking, ultimately to arrive at a score that tries to find those funds that takes singles, if we’re going to use a baseball analogy,” Mallen said. “We don’t just search for the best performing fund on a one-month or one-year basis, we want that fund that shows consistency, and ability to outperform its stated slot within a portfolio.”

Looking at the current investment landscape, Mallen said they tend to favor ETFs across most of their positions within its portfolio.

“Historically, mutual funds were used in our multi-sector allocation, simply because there was a lack of offerings in the multi-sector fixed income space for ETFs,” he said. “I think DIAL fits in really nicely there. They take a good approach to understanding that fixed income isn’t just U.S. Treasuries and high quality corporate bonds – it’s a more diversified asset class that you can harness the correlation between various fixed income sectors to achieve a better risk-adjusted long-term return… and all of that a very palatable cost.”

Financial advisors who are interested in learning more about income strategies can watch the webcast here on demand.