Bond Managers Want in on the Smart Beta Action

Seeking an alternative to traditional capitalization-weighted benchmarks, BlackRock, Northern Trust and other firms are launching smart beta bond funds.

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Asset managers are rolling out smart beta bond funds as one answer to shifting ground in the fixed-income markets. Smart beta, industry parlance for rules-based investment techniques, is still in its infancy in the bond world even though it’s a widely used strategy in equities. But bond shops are racing to reinvent themselves and determine how to make money for investors in an environment of anemic yields and a lack of diverse securities, not to mention the omnipresent threat of rising interest rates from central banks. Unconstrained bond funds, which sever managers’ ties to popular benchmarks and give them more freedom to find suitable investments, have gained popularity in the past couple of years. So has smart beta.

“We’ve seen a move to nontraditional index strategies,” says Shundrawn Thomas, global head of the funds and managed accounts group at Northern Trust Corp., which has $8 billion in its 17 FlexShares exchange-traded funds. FlexShares are flexible indexing funds, the Chicago-based firm’s preferred name for smart beta; five of them are fixed-income index vehicles. Thomas notes that indexes like the Barclays Capital Aggregate Bond Index weren’t initially designed to be investable, so it makes sense that investors are evaluating the risks they want to take in their fixed-income portfolios in a different way.

In one example of smart beta development at Northern Trust, the firm created a shorter-duration TIPS, or Treasury Inflation-Protected Securities, strategy after seeing that many portfolios used long-duration TIPS as a hedge against inflation. The longer maturities were overwhelming that hedge. In 2011, Northern Trust launched two funds — the now-$401 million FlexShares iBoxx 5-Year Target Duration TIPS Index Fund and the $2 billion FlexShares iBoxx 3-Year Target Duration TIPS Index Fund — designed to manage the volatility using shorter-duration TIPS. Starting with the investment concept for the funds, Northern Trust went to Markit, a financial information services provider based in London, to create custom benchmarks.

Matthew Tucker, head of the iShares fixed-income strategy team at $4.7 trillion, New York–based BlackRock, says bond returns are primarily driven by duration and credit risk. But the Barclays Aggregate bond index, one of the most common benchmarks for investors’ core bond allocations, represents about 90 percent interest rate risk and only 10 percent credit risk. “For those investors who want interest rate risk, that will work,” Tucker says. “But others are worried about rising rates, and they also want yield.”

With the new iShares U.S. Fixed Income Balanced Risk ETF, which launched in late February, BlackRock set out to create a fixed-income portfolio that better balances interest rate and credit risks. The $74.8 million fund has less duration risk than the popular Agg and is designed to produce more yield.Although BlackRock uses a rules-based strategy, it considers the ETF actively managed. The fund’s managers select bond sectors that historically have generated the highest risk-adjusted returns, such as mortgage-backed securities and high-yield bonds rated double-B and lower. They then seek to balance the risk across each of those sectors. Finally, they use Treasury futures to bring interest rate and credit risks in line.

Tucker emphasizes that smart beta funds have traits of both index and actively managed funds: “Smart beta is rules-based and fairly low-cost but also captures strategies traditionally used by active managers.” BlackRock’s research shows that active managers, for example, are consistently shorter-duration and have more exposure to emerging-markets debt, high-yield bonds and other securities.

The firm’s ETF tries to deliver that same tilt to credit in a risk-conscious and more consistent way, Tucker says. But it differs from an actively managed offering because it’s systematic and less responsive to the markets. BlackRock will probably apply smart beta concepts to global bond, sector and noncore funds; it and Northern Trust offer smart beta strategies in other vehicles, such as separate accounts.

Scott Eldridge, director of fixed-income product strategy for Chicago area–based Invesco PowerShares Capital Management, which has $100 billion in ETFs, says he sometimes gets pushback from institutional investors that are heavily tied to their benchmarks by policy statements and board oversight. “They have to get comfortable with how an emerging-markets debt allocation, say, can move them farther away from their benchmark,” he explains. “Even in the ETF space, they have an attraction to cap-weighted indexes because that is what they’re used to.” Invesco says it has $4.5 billion in smart beta fixed-income funds.

Invesco works closely with big investors to help them understand the differences between its funds and traditional benchmarks including sector, duration or country exposure. “If the traditional benchmark has 25 percent exposure to energy-dependent companies and a smart beta rule set creates something less than that, maybe that’s an opportunity to generate additional alpha,” Eldridge says. “But investors who do it have to truly understand how they are going off benchmark.”

Smart beta has been tough to implement in fixed income, slowing the development of funds. The equities markets are highly efficient, with plentiful information on securities, so an index fund can often easily replicate its benchmark. But most bonds trade over the counter, with less publicly available information about prices, and have finite lives. Portfolios based on an index don’t hold every bond in the benchmark, which would be impossible to buy and sell efficiently. “One of the biggest challenges you have is there isn’t as rich a source of data,” says Northern Trust’s Thomas.

As BlackRock’s Tucker points out, smart beta in equities has the advantage of a couple of decades of academic research behind it. Relatively little has been published on fixed income, even as aging baby boomers become more conservative investors and pension funds load up on bonds to meet their obligations. “I expect we’ll see a lot more research on the entire category of fixed-income investing,” Tucker says. Those efforts may yield more products.

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