Bond ETF investors looking to potentially help generate improved risk-adjusted returns can consider alternative indexing methodology.

On the recent webcast, Traditional Fixed Income versus Factor-Based, Edward Kerschner, Chief Portfolio Strategist for Columbia Threadneedle Investments, argued that sourcing income and managing potential income volatility in this new rate regime presents unprecedented challenges for investors.

“There seems to be a logical inconsistency in utilizing a cap weighted bond benchmark as an investment vehicle,” Kerschner said. “The benchmark index weightings do not foster diversification, with correlations among the components high; positioning investors in the low return/low volatility segment of the market.”

Alternatively, Kerschner advised investors to consider a multi-sector bond strategy that screens for opportunities. Investors seeking higher returns could should move out along the risk-reward profile as an alternative indexing methodology that is not restricted by traditional market capitalization weights could address the investment universe screened by yield, quality and liquidity

Looking at the current market conditions, we see that benchmark U.S. Treasury yields are finally pushing up after falling from 15% back in 1982 to under 2% in 2013 due to loose central bank policy rates and quantitative easing.

“The risk today is that with bond yields so low, a modest uptick in yield would produce negative returns,” Kerschner said.

During the three-decade long bull run that helped push yields to record lows, many passive bond investors have enjoyed strong returns through diversified exposure through something like the Bloomberg Barclays US Aggregate Bond Index. The so-called Agg was comrpised of 9,397 debt securities worth almost $20 trillion.

However, the Agg is not what is use to be. The Agg held 22% U.S. Treasuries back in 2007, but that exposure has increase to 37% of the index today. Factoring in debt issued by government agencies and mortgage-backed securities, the total government exposure is now over 70%, which leaves investors overexposed to a single segment of the market and susceptible to interest rate risks – MBS pass-through and agency securities exhibit a high 0.81 and 0.93 correlation to U.S. Treasuries.

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