As we brace for the Federal Reserve’s changing monetary policy outlook, investors are beginning to look into alternative ETF strategies with more favorable risk and reward dynamics.
“Investors know that interest rates have to rise from here and there is a real appetite among clients to find more intelligent ways of managing the risks facing their fixed income portfolios,” Nizam Hamid, head of exchange traded fund (ETF) strategy for the European arm of provider WisdomTree, told the Financial Times.
Specifically, more are looking into smart beta as an alternative to traditional bond indices, which tend to follow market capitalization-weighted methodologies that lean more toward indebted government or corporate issuers.
Traditional market cap-weighted bond indices “reward the profligate,” Yazann Romahi, chief investment officer for quantitative beta strategies at JPMorgan Asset Management, told FT. “There is demand from investors for better diversified fixed income indices, but the challenges in building smart beta strategies for bonds are much more nuanced than in equity markets.”
Data issues have impeded the growth of smart beta bond ETFs. Obtaining accurate data on debt securities is problematic as many transactions are private over-the-counter deals, unlike trades on a regulated exchange.
Related: A Multi-Factor, Smart Beta ETF for Long-Term Investors
Nevertheless, some ETF providers have already launched smart beta bond strategies. For instance, Invesco provides U.S. corporate bond ETFs that weight components by an issuer’s cash flow, sales, book value and dividends. The $1.1 billion PowerShares Fundamental High Yield Corporate Bond ETF (NYSEArca: PHB), which tracks the RAFI Bonds US High Yield 1-10 Index, focuses on slightly higher quality corporate debt securities than its major competitors.
Paul Syms, head of fixed income product management, Emea, at Invesco PowerShares, argued that there is “a real thirst” among investors to understand such strategies. Over half of investors who do not currently use smart beta would consider applying its techniques to equity investment. But investor interest in applying smart beta to fixed income ranges from 24% for sovereign debt to 45% for corporate bonds.
“Fixed income smart beta is the investment frontier that matters most to clients and we are seeing more strategies under construction. Clients are even willing to trade yield [and accept lower levels of income]if these strategies can help them to control risks in a rising rate environment,” Hamid added.
For more information on the fixed-income market, visit our bond ETFs category.