In part 1 of this article, we looked at the first two questions to ask when evaluating strategic-beta fixed-income funds. In this part, we will look at the remaining two questions.
How Does the Index Weight Bonds?
GIGB employs a market-cap-weighting approach for its holdings while excluding the bottom-decile group based on its screening method. The resulting portfolio has 45% allocation to BBB rated bonds and 40% exposure to A rated bonds. Its sector allocations were approximately 65% industrial and 30% banking as of June 13, 2018. GIGB's market-cap-weighting coupled with its emphasis on leverage gives the portfolio a slight tilt toward large industrial firms with big balance sheets, such as Alibaba (BABA, listed in the U.S.) and Verizon (VZ, listed in the U.S.). Due to its broad reach and market-cap-weighting approach, the strategy is likely to display a high correlation with the plain-vanilla market-cap-weighted Bloomberg Barclays US 5-10 Year Corporate Index, which Silver-rated Vanguard Intermediate-Term Corporate Bond ETF (VCIT, listed in the U.S.) tracks.
IGEB again utilizes its opaque optimization method to weight its holdings to maximize the portfolio's expected return metric, which is calculated as OAS minus probability of default times 1 minus recovery rate assumption. Though the optimization goal is sensible, it still lacks transparency. The resulting portfolio had a sector breakdown of 75% industrial and 10% banking, and a credit rating distribution of 80% BBB and 20% A, as of June 13, 2018. Given the less-than-transparent construction process, it is unclear how the sector and credit rating distribution will change over time and the implication for investors.
GIGB rebalances monthly and does not have any specific reconstitution constraints, which means this strategy could be exposed to sector-concentration risk. This is because its cap-weighted portfolio is heavily influenced by underlying debt-issuance activities. For example, large international banks are some of the most active debt issuers. Consequently, 30% of the portfolio is invested in financial bonds. This sector tilt, however, is on par with the portfolio's starting universe (the Citi USBIG Corporate Index), as well as the popular cap-weighted corporate bond index, the Bloomberg Barclays US Corporate Index. At the same time, this market-cap-weighting method reduces turnover and transaction costs.
IGEB has an explicit 12% turnover limit for its monthly rebalancing. In addition, the fund's duration, duration-times-spread, and issuer weights are kept close to its underlying index.
How Much Active Risk Does the Fund Take?
The degree of active risk for both funds is manifested through how they select and weight their securities. Overall, IGEB pursues its factor tilts more aggressively than GIGB does, giving it greater upside potential while assuming more downside risk. First, IGEB excludes 20% of its starting investment universe, while GIGB only removes 10%. Second, IGEB optimizes its holdings to maximize the portfolio's spread; meanwhile, GIGB simply weights its positions by market value. This construction approach causes IGEB's portfolio to deviate further from its starting universe than GIGB, giving it greater active risk.
IGEB's allocation to bonds rated BBB, a notch above junk, was 30 percentage points more than the Markit iBoxx USD Liquid Investment Grade Index's. In contrast, GIGB's BBB exposure is currently in line with that benchmark's. If credit risk continues to pay off, IGEB is highly likely to best GIGB and vice versa. However, BlackRock's opaque security-selection process is less appealing than Goldman Sachs' straightforward approach since it is difficult for investors to anticipate how IGEB would behave under extreme market conditions.
Conclusion
Investors have been reluctant to dabble in these so called smart, or strategic-beta, fixed-income funds not only because of their limited records but also because of their complexity. But investors can always start by asking the four questions, no matter how complex these strategies look or sound, in order to narrow down their choices.
Both GIGB and IGEB start from the sensible investment-grade bond universe. GIGB then utilizes accounting data to select its bonds and market-cap-weights them. IGEB constructs its portfolio through its proprietary algorithm that incorporates market data. GIGB's major drawback is its usage of backward-looking accounting data. However, IGEB's black-box-like security-selection and portfolio-construction methods pose risks, including uncertainty around its responses to market stress. IGEB does take more active risk by pursuing its targeted factors more aggressively than GIGB, giving it greater potential to outperform, but also greater downside risk. Investors should be wary of this risk, especially because this strategy has not been proven yet.
