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Four Questions for Evaluating Strategic-Beta Fixed-Income Funds (Part 1)

It is not as daunting as it looks.

Phillip Yoo 02/08/18

Strategic-beta (often called "smart beta") fixed-income funds attempt to offer the best of active and passive management: benchmark-beating performance with transparent portfolio construction rules and low fees. Evaluating strategic-beta fixed-income funds can appear to be complex. However, by asking the following four questions investors can easily perform litmus tests on this new breed of fixed-income funds.

  1. What is the investment universe?
  2. How does the strategy select bonds?
  3. How does the index weight bonds?
  4. How much active risk does the portfolio take?

The investment universe provides a rough idea of how risky the strategy may be. For example, a junk-bonds-focused fund is likely to exhibit higher volatility than an investment-grade-oriented strategy. Also, this starting point serves as the yardstick against which an investor can measure whether a strategic-beta fund has delivered value.

The process by which a fund selects and weights securities is the most important area to evaluate to understand how it will likely perform. Investors should be wary of strategies that aren't supported by a clear economic theory, like ProShares S&P 500 Bond ETF (SPXB, listed in the U.S.) (expense ratio: 0.15%), which selects bonds from S&P 500 companies. There isn't a compelling rationale for forming a bond portfolio on the basis of an equity index.

Investors must look for an investment thesis supported by a sensible economic rationale, and must be cautious about strategies heavily relying on back-tested results. For example, Invesco Fundamental High Yield Corporate Bond ETF (PHB, listed in the U.S.) (expense ratio: 0.50%) utilizes dividends and the book value of issuers, among other metrics, to select its holdings. Although PHB's underlying index, the RAFI Bonds US High Yield 1-10 Index, does have an impressive back-tested risk-adjusted return record (measured by Sharpe ratio), the accounting metrics underpinning the strategy are loosely tied to issuer credit quality, which is one of the best predictors of expected returns for high-yield bonds.

It is important to carefully examine how the fund defines the factors it uses to select securities. There is a virtually infinite number of factors to choose from, since it is up to a fund company's discretion to define what constitutes a factor. For example, iShares Edge Investment Grade Enhanced Bond ETF (IGEB, listed in the U.S.)'s definition of quality and value is based on its own calculation of an issuer's default probability, which is likely to be different from estimates by other fixed-income managers and credit rating agencies. Irrespective of their definitions, however, factors that strategic-beta funds deliver often repackage traditional credit and duration risk, which are available more cheaply from market-cap-weighted funds.

Active risk is necessary to beat traditional market-cap-weighted benchmarks. Funds that stray further from those benchmarks (taking greater active risk) have greater upside potential, but also greater potential to underperform. The magnitude of a fund's active risk is determined by how aggressively it pursues its targeted factors, including how stringent its selection criteria is and how it weights its holdings. Tracking error relative to a cap-weighted benchmark is a useful gauge to assess how much active risk a fund takes.

Below, I will apply the four-question framework to Goldman Sachs Access Investment Grade Corporate Bond ETF (GIGB, listed in the U.S.) (expense ratio: 0.14%) and IGEB (expense ratio: 0.18%) to demonstrate how they can help investors better understand strategic-beta ETFs.

What Is the Investment Universe?
The investment universes of GIGB and IGEB are nearly identical except for their minimum issue size. Though less relevant for these two funds, the issue-size criterion can be an important distinction when evaluating other portfolios. This is because the liquidity of a security is directly related to its issue size, and the liquidity of constituent securities in an index dictates whether the benchmark can be replicated at reasonable costs. GIGB tracks the Citi Goldman Sachs Investment Grade Corporate Bond Index, which has a minimum issue size of $750 million, whereas IGEB's benchmark, the BlackRock Investment Grade Enhanced Bond Index, requires a minimum amount outstanding of $500 million. The $250 million difference may look significant, but it is unlikely to affect IGEB's index-tracking capability given the ample liquidity of the U.S. investment-grade bond market. However, it is likely to cause IGEB to lag its index more than GIGB does during market downturns when liquidity evaporates. Both funds invest in U.S.-dollar-denominated, BBB or higher-rated corporate bonds with at least one year remaining until maturity.

How Does the Strategy Select Bonds?
GIGB ranks bonds by their year-over-year changes in leverage (debt to enterprise value) and operating margin (EBIT over revenue) ratios within its larger-issuer biased universe. The bottom-decile-ranking issuers are then removed. This is because the bottom-decile group historically exhibited unfavorable risk/return traits. The bottom band experienced twice the standard deviation while delivering one third the return among its investment-grade bond peers from February 2007 to November 2017, according to Goldman Sachs.

This approach captures the improving or declining health of companies better than a traditional index, which takes a snapshot of debt loads at a given point in time rather than how those metrics change over time. Goldman Sachs developed this screening tool in collaboration with its internal actively managed fixed-income credit analysts, who believe these two accounting-driven measures (leverage, a balance sheet ratio; and operating margin, an income statement ratio) are good indicators to avoid companies with deteriorating fundamentals.

On the other hand, IGEB incorporates myriad market data such as the prices of issuer's equity and options, as well as economic variables, to estimate their probability of default over the next 12 months. The strategy's quality factor screen then removes the 20% of issuers with the highest probabilities of default within each credit rating bucket. Based on its default estimate, the portfolio recalculates the option-adjusted spread of the remaining securities, and tilts toward the bonds with the widest OAS. This step is IGEB's way of capturing a value factor. BlackRock relies on market data more than accounting numbers because it believes quarterly financial statement data are slower to detect deteriorating fundamentals than market prices.

Both accounting-driven and market-driven approaches are sensible ways of measuring default risk. GIGB's accounting-based methodology is transparent and simple to understand. But the strategy's reliance on accounting data exposes it to possible financial manipulation and this data is backward-looking. On the other hand, IGEB constructs its portfolio based on forward-looking measures such as stock prices and options, which could be quicker to detect deteriorating fundamentals than accounting data.

In part 2 of this article, we will look at the remaining two questions to ask when evaluating strategic-beta fixed-income funds.

About Author Phillip Yoo

Phillip Yoo  

Phillip Yoo is an analyst, passive strategies research, for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc.