Can Smart Beta Work for Fixed-Income ETFs?

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.