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Fixed-Income Insights

The “smart beta” investing approach, which has become popular in the equity sector, is now starting to gain traction among fixed-income investors. But do they really understand how it works? 

 

In Brief

  • Fixed-income managers are starting to introduce “smart beta” funds, which use indexing based on nontraditional factors to weight portfolio holdings.
  • But smart beta may be more aptly termed “tilted beta,” because the risk structure and performance profile may be tilted toward different risks than traditional indexes, such as the broad-based Barclays U.S. Aggregate Bond Index.
  • The new, tilted portfolio is, therefore, not necessarily “smarter,” especially if an economic or interest-rate environment unfolds that is different from what was assumed during its design.
  • Because smart beta bond funds more precisely define the risk or the economic environment in which they perform, they likely need more oversight and management than more traditional funds do.
  • The key takeaway—Smart beta funds may be less attractive to those investors who believe opportunities to generate outperformance are more likely to be realized with the resources and investment professionals of actively managed portfolios.

 

“Smart beta,” which has attracted a lot of attention among equity investors, is now poised to do the same with fixed-income investors. A recent article in Institutional Investor, for example, noted that asset managers are “rolling out smart beta funds as one answer to the shifting ground in the fixed-income markets.”1 The strategy refers to indexing using nontraditional methods to weight portfolio holdings. In the equity market, smart beta is often captured by replacing traditional capitalization-weighted benchmarks with equal weightings. An equal-weighted benchmark, in effect, overweights small caps and underweights large caps. Other factors used in smart-beta weightings include price-to-book value ratio, which overweights value stocks. Such adjustments tilt a portfolio’s holdings toward factors that the managers believe will drive performance. 

How does this work? In the example of equal weighting, the new index becomes “smarter” because it tilts the portfolio toward issues with smaller capitalizations. The use of factors such as price-to-book value can tilt the portfolio toward value stocks. The new index may not necessarily be smarter, however. It just may be focused more on a specific factor like the ones listed above—while assuming the attendant risk.

Within fixed income, smart beta appears to have some fundamental justification. The primary flaw in traditional passive bond indexes is that the most indebted issuers tend to be the most heavily weighted. It would seem that any modification to such an index that re-weights securities in a more sensible, and less concentrated, approach would produce smart beta.

However, much like similarly focused equity indexes, changes to a bond index to capture smart beta will change the risk profile and performance characteristics of the underlying portfolio. This does not mean, however, that the smart beta portfolio will outperform the original “dumb beta” approach. For instance, the benchmark Barclays Aggregate U.S. Bond Index carries interest rate risk of about 90%, according to Reuters. A smart beta strategy may seek a balanced approach to dampen interest rate risk by tilting index construction to add more credit risk by including high-yield securities. The new smart beta portfolio would be more diversified, would likely feature a higher yield, and may perform better in a rising rate environment than the original Barclays Aggregate bond index. It certainly sounds “smart.” 

Not So Smart?
However, the introduction of additional credit risk suggests the smart beta portfolio may underperform the Barclays Aggregate if fears of economic slowdown increase or geopolitical concerns spark a flight-to-quality bid in the market. Thus, smart beta may be more aptly termed “tilted beta.” The risk structure and performance profile are tilted toward a different risk than the original index. The new, tilted index is, therefore, not necessarily smarter, especially if an economic or interest-rate environment unfolds that is different from what was assumed during its design.

This becomes an even greater concern given one of the fundamental observations of behavioral finance: investors tend to overweight recent experience in their investment decisions. For example, the downdraft in oil prices from October 2014 through March 2015 was reflected in poor performance of the debt of many energy companies, particularly those in the high-yield sector. Investor concerns about this experience might have influenced their decision to avoid such volatility in the future, i.e., steer clear of energy securities. A smart beta index that eliminated the volatility of the energy sector by excluding it from the index might appeal to investors stung by the oil price decline. 

But investors purchasing a smart beta fund that avoided the energy sector would have missed the positive market effects of the recovery in crude oil prices in April 2015. This is an extreme example, but it underscores that when investors select smart beta indexes, their traditional behavior patterns could produce disappointing results by mistiming their new risk exposure, or misunderstanding the consequences of the smart beta change. To the extent investors use index funds to time the market, their behavior could produce poorer economic results than the term smart beta may imply.

Avoiding Mistakes
Simple mistakes, such as mistiming investment decisions, allowing emotion to influence portfolio moves, or misunderstanding the impact of smart beta, can be overcome. As with most investments, adopting a longer investment time frame and executing investment decisions periodically can mitigate the effects of mistiming. Consciously evaluating emotions and related investment behavior likely can promote objectivity. And marshaling personal resources to better understand the design of smart beta also can lead to improved investment decisions. 

Regardless of where an investor finds the necessary resources, it is important to recognize that smart beta bond funds are attuned to perform in particular market and economic conditions; since those conditions may vary over time, the funds are likely to need more management oversight than their dumb beta predecessors. A change in economic growth, interest rates, or geopolitical risk could diminish the prospects for outperformance for specific smart beta funds, prompting investors to head for the exits. Similarly, there may be opportunity costs for smart beta funds that are purchased in anticipation of a particular market or economic environment that does not pan out as anticipated. For example, many investors positioned their portfolios at the start of 2014 for an expected increase in interest rates; instead, rates declined, leading to underperformance for the year.   

It may be that for many investors smart beta funds lie in a no-man’s land between broad index funds and actively managed vehicles. Broad index investors may prefer to accept market movements without the responsibility of having to revisit strategic weightings of smart beta funds as the investment landscape changes. At the other extreme, smart beta funds are unlikely to appeal to those investors who believe outperformance is more likely to be realized via the resources and investment professionals of actively managed portfolios. Investors intrigued by the prospect of a new, intelligent strategy may be disappointed to find that the “smartness” of smart beta begins and ends with the portfolio’s highly focused exposure to a particular investment risk. An even smarter approach might be to employ an active manager who can respond to changing market conditions through disciplined security selection. 

 

1Julie Segal, “Bond Managers Want In on the Smart Beta Action,” Institutional Investor, April 15, 2015.  

 

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