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This Firm is Warning Investors to Be Wary of Smart-Beta Bond Funds

Asset managers see big potential in factor-based fixed-income funds, but early product attempts are confusing at best, a research firm contends.

Smart beta may be one of the hottest areas in the asset management business, but investors need to be cautious about fixed income funds plying this technique, as the current category contains a range of diverse offerings that are easily misunderstood, according to a research firm.

“The smart beta label still represents a small, new, heterogeneous, and most likely misunderstood, group of exchange-traded funds in the fixed income space,” says Megan Woods, an analyst with investment research firm Markov Processes International.

According to research done for Institutional Investor by MPI’s Woods, the funds — because their construction varies considerably from product to product — may behave differently in their portfolios than investors expect. The confusing array of products may also put a damper on their popularity.

Smart-beta funds have been appealing to investors in large part because they are a transparent alternative to actively managed funds. Factor-based funds, also commonly called smart beta, are investments based on algorithms that are designed to find securities that meet certain criteria, such as low volatility, or track a custom benchmark.

Asset managers including BlackRock, Goldman Sachs Asset Management, and J.P. Morgan Asset Management are racing to develop smart beta fixed income funds, hoping to piggy back on the popularity of similar portfolios in the equity world.

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Analyzing 62 funds defined as smart-beta fixed-income by news and data website at the time of the research, MPI found that these funds cannot be easily categorized into distinct fixed income sectors. Looking at fundamental high-yield funds, MPI, for example, found that two ETFs follow a different strategy from the other three in the group.

Woods also found that even the overall category changed dramatically over a short time period. In December of last year, listed 25 smart-beta fixed-income funds. Two of the largest of those funds have since been removed, while the category now includes new launches as well as previously existing funds that have since been re-categorized as smart-beta fixed-income.

It’s not surprising that factor-based bond funds are a confusing category. Although research on factors that explain equity returns is decades old, similar research in fixed income is just getting off the ground. As an example, Cheyne Capital Management, an alternative investment firm, formed a partnership earlier this year with portfolio analytics provider Novus to build a tool for fixed income securities analytics. The firm was interested in forming a venture with Novus because it wanted to have a better command of factor investing in the credit markets, where research is still nascent.

In addition, though smart beta bond funds are marketed as transparent, Woods found that it was actually difficult to get enough information to do a thorough analysis.

“With transparency being a significant driver behind the allure of smart beta, factor investing, and ETFs in the equities space, the paucity of information and data for investors to evaluate the mostly young product set in the fixed-income space and educate themselves is notable,” says Woods.

MPI also found that the custom benchmarks that smart beta funds are being compared to don’t have publicly available historical information that would allow investors to educate themselves about the funds’ performance and behavior.

Woods suggests that investors remain cautious on the category despite its theoretical appeal. She recommends investors look for funds that have simple and clear objectives and use traditional widely available benchmarks to compare the funds’ performance. In addition, she says investors should ask asset managers to provide data from backtests to see how the funds have performed through an entire credit cycle.

“Defining and categorizing smart beta in fixed income products looks to be even more challenging than in the rapid growth realm of equity smart beta,” says Woods.

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