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Can Smart Beta Work for Fixed-Income ETFs?

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There seems to be no end to the creation of smart-beta exchange-traded funds with an equity twist.

But smart beta’s adoption by fixed-income ETFs is “very much in its infancy,” says Steve Laipply, senior product strategist with BlackRock’s Fixed-Income Portfolio Management group.

“As far as adoption goes, I think we are still in the early days, but the interest in these strategies has grown significantly and that’s mainly due to the low yield environment we’re in,” said the iShares managing director, who is based in San Francisco.

“As yields have stayed at these low levels, investors are looking at ways to generate additional yield and outcomes without taking on a significant increase in risk,” Laipply stated.

A Limited Factor Set

Researchers generally identify three key factors that can generate fixed-income return premia, according Riti Samanta, head of quantitative research and senior product manager of State Street Global Advisors’ Fixed Income, Cash and Currency group: credit premium, liquidity premium and term premium.

The credit premium provides compensation for the accepting the risk of issuer default. Liquidity premium reflects a fixed income security’s market liquidity, and the term premium compensates for the fact that longer-maturity debts’ prices are more volatile.

Mapping these factors and capturing their premia is the role of smart beta, explains the Boston-based Samanta.

For example, State Street believes that much of bonds’ credit premium is actually compensation for taking default risk. If the market is overestimating a security’s default risk, investors can extract the default risk premium and earn an excess return over time as the market corrects to fair value.

From Theory to Product

Laipply points to two iShares ETFs as examples of how smart beta can be implemented flexibly with fixed income.

The iShares Yield Optimized Bond ETF (BYLD), which has about $15 million in assets) aims for the same level of volatility as the overall U.S. bond market, but with a goal of increasing yield by optimizing holdings, which can include high yield and foreign bonds.

The iShares Edge U.S. Fixed Income Balanced Risk ETF (FIBR), which has close to $71 million in assets, holds U.S. bonds and attempts to balance interest rate and credit risk to provide better risk-adjusted total returns.

The funds have performed well versus their benchmarks this year, he says. (BYLD was up about 7% in price through Aug. 31, while FIBR had risen 6% in the first eight months of the year, according to Morningstar.)

New Products

State Street recently launched ithe Multi-Factor Premia Emerging Bond Markets Bond Fund (SPED). It invests in local-currency sovereign debt and has attracted roughly $170 million since it started operating in April, Samanta reports.

Other sponsors, including FlexShares, PowerShares and Vident, also offer smart-beta fixed income ETFs in what remains a niche ETF market. estimates that as of August 2016, only 23 of 315 fixed income ETFs used smart-beta strategies. Those 23 funds held a relatively small $9 billion of assets, with $1.84 billion of that total in FlexShares’ iBoxx Three-Year Target Duration TIPS Fund (TDTT).