Practical analysis for investment professionals
31 October 2018

Smart Beta: How to Avoid Fixed Income’s “Crocodile Jaws”

Interest rates, as measured by the three-month Treasury yield, are the highest they have been in 10 years and trending higher.

Fixed-income investors are facing a conundrum. Some would call it crocodile jaws.

On top, the higher rate from the US Federal Reserve is slamming down on the value of bond portfolios. On the bottom, risk, as measured by duration and credit spreads on high yield, continues to rise.

Can smart beta help bond investors escape these jaws? We asked Salvatore J. Bruno and Kelly Ye, CFA, managing director and chief investment office, and director of research, respectively, of IndexIQ, a subsidiary of New York Life Investments, for their take on what’s next for bond investors. Bruno will be sharing some of these insights at the Inside Fixed income and Dividend Investing Summit in Newport Beach, California, on 13 and 14 November.

Below is a lightly edited transcript of our discussion.

CFA Institute: Why should investors allocate to fixed income in this environment?

Salvatore J. Bruno: There are important reasons to allocate into fixed income, even during periods of rising rates. Number one, it can provide diversification as a traditional hedge against equities.

Secondly, investors still do need income. Especially on the shorter end of the curve with rates in the US now in 2 to 2.25% range, yield is starting to become more attractive from an asset allocation standpoint.

Headline rates are starting to hit where inflation is at. We’ve dug out of the hole of negative real rates, so at least now you’re at zero, which may sound crazy, but it’s actually better than where we’ve been over the last 10 years.

Even on the long end of the curve, we’ve seen rates run up a little bit, topping at 3.25%. We’re not in the business of forecasting long‑term interest rates, but there is this school of thought that it may not go much higher than that. That may mean some future capital appreciation.

Credit spreads have remained fairly tight, generating some attractive returns in both investment grade — especially if you’re on the shorter end of the curve – and in high yield as well. We’ve seen a lot of higher returns, especially in some of the lower-quality credits.

Mutual funds still dominate fixed-income allocation. Why are ETFs playing a larger role in this space?

Bruno: Fixed income can be packaged rather neatly in ETF wrappers by systematizing some of the ways that active managers invest. We also try to move a little bit away from the traditional market capitalization-weighted indices.

That’s where the smart beta conversation starts to pick up. In many ways, it is similar to the rules‑based or smart beta approach on the equity side, by capturing the essential thought process that drives the portfolio management on security selection within the asset class. As well as systematizing in the ETF wrapper, we take some of the emotion and biases out of the investment process.

Smart beta solutions go back to Kenneth R. French and Eugene F. Fama’s research into equity factors. How do you construct smart beta ETFs in fixed income?

Bruno: Fixed income is a little bit of its own animal, different from equities. We do not look at factors and say, “Well, this factor works in equities. Can it work in fixed income?” but approach it from a solutions‑based standpoint.

What are some of the problems that fixed-income investors face? Are there ways that we can use traditional factors that have worked well on the equity side and apply them to fixed income?

For example, one of the factors we’ve looked at is the popularity and effectiveness of low-volatility investing on the equity side. Given the similarities between high‑yield corporate bonds and equities, we analyzed what happened in 2015 and 2016 when credit spreads blew out.

A lot of investors had been chasing yield because interest rates had been so low and really overpaid for high yield. We asked ourselves, “Is there a better way to do low-volatility investing in high yield?” We started thinking about this investor’s problem and what the solutions could be. Our answer is low volatility within high yield.

Kelly Ye, CFA: There are a few factors that work across asset classes because they are backed by sound economic or behavioral rationale. The graph below shows momentum, low vol, quality, and value are all factors that could work in both equities and fixed income. Quite a few papers show factor efficacy across asset classes, and active managers have long been using those factors in their investment process. The difference between factor application in equities and fixed income lies in their factor definition.


Factor Investing

To meet investor needs, active managers have been using factors to select securities for decades.

Factor Investing Chart Fixed Income


Use volatility for example: In equities, volatility is defined as either realizable volatility or the portfolio volatility taking into consideration correlation. In fixed income, not every bond is traded every day, so price volatility may be unrepresentative. Research existed almost 15 years ago that the volatility of a corporate bond may be measured by its duration and credit spread in a measure called DTS. It has now been widely used by active managers as a quantitative risk measure. It is derived from a bond’s market price, which is a more responsive measure than bond ratings

Momentum is another example. In equities, momentum is evaluated over a long horizon, like six months to a year. Fixed-income bonds do mature, changing our time scale. We tend to look at momentum in a shorter time window. Furthermore, fixed income is not generic. You have interest rate‑related products such as Treasuries. You have credit‑related products such as corporate bonds, and you have some more convexity products like mortgage‑backed securities. To allow for comparison across all those different building blocks with different types of risk-return characteristics on the same basis, we had to adjust momentum by their risk profile.

Do these complexities explain why active managers often claim to outperform passive fixed-income ETF strategies?

Bruno: Perhaps. Surprisingly, we would agree that the basic concept behind the act of just weighting bonds by the amount outstanding leads to riskier bonds becoming the biggest weights. A potentially flawed benchmark is one of the main reasons for fixed-income active management.

In fact, when you look at the aggregate bond index, empirically what we’ve seen since the financial crisis as interest rates went from 4% to zero, is an increase in risk. Duration, as a risk gauge, went from three to six years. I call it the crocodile chart because you can kind of see the jaws opening.

Investors have seen this and said, “I’m taking on a lot more risk for a lot less yield right now, so just to do passive investment, that doesn’t seem to make a whole lot of sense, but I know I still need bonds. So are there better ways to try and get bond exposure?” This leads not only to the preference for active management, but also towards a halfway solution of smart beta in fixed income.


Historical AGG Index Duration and Yield

Historical AGG Index Duration and Yield

Source: Bloomberg


Ye: We don’t think smart beta equals passive investing. It attempts to implement well-established investment processes in a rules-based format and removes the emotional component associated with discretionary managers.

Smart beta may help escape the “crocodile jaws” of unfavorable risk-reward. Other than lower expense, what should investors consider?

Bruno: One of the most important things to understand is what the smart beta product is trying to solve for. That really drives the evaluation process. Many people think Smart beta is always about excess return, but it’s not always the case. Sometimes you’re creating products to try to create specific exposures for certain environments.

Our research shows over the full cycles, using low-volatility high‑yield bonds can be quite a good way to deliver some excess return with a lot less risk. Over shorter periods of time, especially if higher quality credits are underperforming, a low‑volatility approach may actually put you behind from a performance standpoint, but it’s still trying to dampen some of the volatility.

Again, in the short run, you’re maybe trying to reduce volatility, but over a longer period of time, it becomes more of a performance play. Part of it is a time horizon, and part is understanding what the objective of the strategy is. Smart beta is not one size fits all and may not be the superior solution for every environment.

Choosing the right benchmark seems to be paramount.

Bruno: The benchmark can vary by time horizon.

Through the full long-term cycle, from credit contraction to expansion, a lower volatility metric like a high‑yield low-volatility bond index makes a lot of sense. You’re trying to lose less on the downside, so you don’t have to make up quite as much on the upside.

This way you get outperformance over the full period. That can lead you to a situation, if you’re using a broad‑based index over shorter periods of time and credit spreads are narrowing, we know that is something that is going to be where more high quality was likely to underperform.

There, you may want to fine tune it a little bit more to maybe a BB bond index, where it’s a little bit more in tune to that specific environment. Again, it gets back to understanding what the strategy’s trying to do, and the benchmark actually may be different, depending on your time horizon.

Ye: Also, to leverage on that, if you are thinking about the end investor, whether their goal is building up wealth, managing volatility, or tax efficiency, the first level of the benchmark is the investment strategy, be it an ETF or mutual fund, is satisfying that goal.

The second layer, especially as you are evaluating a rules‑based solution, is whether the product is delivering what it’s supposed to deliver. Smart beta solutions can come with a lot of innovation and creativity, but ultimately you are not comparing them to a universal benchmark but to what the index rule is saying the strategy is going to do.

How do you think about the underlying liquidity? What does it mean for the way ETFs trade bonds?

Bruno: Liquidity is of paramount importance in any instrument but especially in bonds. We always think when we’re constructing a strategy or an index: Can we effectively implement it? Depending on how we’re constructing it and what strategy we’re trying to do, that may have different considerations for the actual building blocks that we select.

For example, momentum strategies, by definition, have much higher turnover than most others. At the individual bond level, it requires running every month an algorithm to select those with the highest momentum. These bonds are overweighted relative to others.

Transaction costs, if elevated due to the illiquidity, may eat up any potential benefit from the security selection. In that particular case, we decided to allocate, not at the individual bond level, but at the sector level by investing in liquid proxies in the form of other ETFs.

Many of these other ETFs have a liquidity that exceeds the actual underlying bond liquidity because they trade so much in the secondary market.

A strategy whereby maybe you’re trading a corporate bond ETF and some different slices of the Treasury yield curve enjoys a far greater liquidity than that available in the individual bonds.

Ye: In managing liquidity, in fixed-income ETFs, there are two layers to consider. One is at the strategy design level. If it’s a bond ETF, then we have to embed liquidity criteria. Rather than buying all the bonds in the index, you have some liquidity in terms of size and trading volume.

The other layer is actual management to the tracking error. This is where, fixed-income and equities ETFs differ. A professional team skilled in trading fixed income where it is over the counter, even if it’s a rules‑based strategy, is essential to manage liquidity.

For some of our bond ETFs, trading is managed out of our MacKay Shields fixed-income management arm, which has extensive experience in accessing liquidity.

Proverbial “crocodile jaws” really begin to bite when liquidity dries up. How would ETFs fare in an illiquidity-induced crisis?

Bruno: Firstly, ETF investors have access to the secondary market by choosing to sell their ETF shares. According to some estimates, on average during normal times, ETFs trade $7 in the secondary market for every dollar of primary market activity.

The amount of assets that are in high-yield ETFs is actually very small in comparison to the overall high-yield market. Fears of ETFs triggering a crisis seem a little bit overblown because they account for a small share of all holdings.

At the end of the day, you do settle back upon the redemption process. The portfolio manager, if there was a big run on the ETF with lots of redemptions, can deliver the bonds to the authorized participant. thereby avoiding having to sell those bonds and raise cash.

Even if the portfolio manager had to sell the bonds instead of doing an in-kind redemption, it is no worse than a mutual fund, which is basically doing the exact same thing. All we’ll need is to sell the bonds and try and raise cash to meet the redemptions. From this perspective, I think ETFs get a bad rap relative to mutual funds, which are in the same boat.

Regarding implementation, what trading considerations should investors take into account?

Bruno: When we talk to our clients about implementation, we encourage them to follow the best practices.

Try to avoid when the markets open and close. At these times, authorized participants and market makers are trying to figure out what’s going on and how to price their books most effectively. You don’t have to wait hours, but maybe a few minutes around the market open, and if it’s a volatile day, maybe try to avoid the close.

Always use limit orders. Don’t just put market orders out there and pray for the best, because there are professionals out there who are going to make a market there and try and pick you off at any price they can if you don’t put a limit order.

For larger clients, we recommend getting multiple bids and see if they can do something on a principal basis, perhaps, as opposed to just an agency basis.

We encourage going out to two or three market makers, people we know who actually understand our funds and are best positioned to price risk and ask for blind bids. Don’t tell them what side of the trade you want to be on. Just say, “I want to do X number of shares.” Don’t tell them if you’re a buyer or a seller and ask them for a two‑way quote. This will help keep them honest, because they can’t just rig it to one side. We’ve found that works out very well, especially for larger customers who are trading in quantity to get best execution.

The tax efficiency of ETFs relative to mutual funds: How does it play out in fixed income?

Bruno: Tax treatment varies within fixed income, depending on the ability to do creations and redemptions in‑kind or in cash. ETFs vary. Some will only do cash. Many others will do in‑kind to the extent that you can do an in‑kind.

There is a proposal for a new SEC rule that should allow for more in‑kind activity, which is the type that generates the tax efficiency. That’s really what creates the tax efficiency by being able to remove out securities that are sitting at unrealized gains as part of that basket.

If you get a redemption, and in our example before, instead of the portfolio manager having to sell to raise cash to meet the redemptions, they’re delivering a pro-rata slice of the portfolio out to the authorized participants in a tax‑free exchange for the shares of the ETF. That’s really the key to the tax efficiency: the ability to meet redemptions without having to sell and realize capital gains. The information on whether an ETF is tax managed is publicly available, of course.

Say it’s 2028, and ETF assets in equities falls to 50%. What would cause such a dramatic re‑rating of investor preferences towards fixed income and alternatives?

Bruno: I would say it would have to be a large re‑rating of risk in the marketplace, especially the way we’ve seen the equity markets since the crisis. We’ve seen a dislocation or an unmooring of price action with fundamentals in the equity markets. More recently, equity prices accelerated to almost growth at any price instead of growth at a reasonable price.

If things were to reverse in a large way and you see repricing of risk in the equity markets, one place people may go would be fixed income. In order to get to a 50/50 split on the assets in the ETF industry, you’d have to have a pretty sustained equity bear market.

Ye: Fixed income as an asset class is much bigger from a market-cap perspective than equities. I think it’s a matter of continuing education for people to understand the fixed-income market and feel comfortable with fixed-income strategies. The responsibility is on ETF issuers like us to make sure that our products are designed to best solve investor’s problems.

Bruno: Investors used fixed income for risk mitigation because of its negative correlation to equities. In a rising rate environment like now, the benefit of fixed income might be diminished. Additionally, we’ve seen increasing interest in alternative investment strategies, as they tend to be lowly correlated to equities, in some cases negatively correlated to fixed income.

Alternatives have delivered a positive absolute return over time. I think of those almost as getting paid to carry insurance. Instead of a negative correlation to the equity markets, you have zero correlation. You have a positive carry on that.

To the extent you’re generating positive returns, they can do well when equity markets take a tumble or fixed income doesn’t do quite as well if rates start going up. You may see a lot of interest investing in liquid alternatives in the ETF wrapper.

For more insights on fixed income, check out “Foundations of High-Yield Analysis” by Martin Fridson, CFA.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/ Delano Balten

About the Author(s)
Paul Kovarsky, CFA

Paul Kovarsky, CFA, is a director, Institutional Partnerships, at CFA Institute.

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