In part 1 of this article, we went through the first 3 questions to ask before buying a strategic-beta bond ETF. In this part, we will run through the remaining 3 questions to ask.
How aggressively does the fund pursue its targeted factors?
Funds that pursue their factor tilts more aggressively have greater active risk: more room to both outperform and underperform. Funds can strengthen their factor tilts by setting more demanding thresholds for inclusion and incorporating factor characteristics into their weighting approach. However, departing from market-value weighting can increase transaction costs and make the fund’s index more difficult to track because most alternative weighting approaches overweight smaller and more thinly traded issues.
Tracking error relative to the fund’s starting universe or category benchmark is a good way to gauge how much active risk a fund takes. This metric shows how much the fund’s performance deviated from that of its opportunity set, due to its active bets. Strategic-beta funds that focus on investment-grade debt tend to have lower active tracking error than those that focus on high-yield bonds.
What portfolio constraints are in place, if any?
While they tend to moderate the strength of a fund’s factor tilts, constraints on a portfolio are usually prudent because they often limit risk and improve diversification. Without them, a fund may be susceptible to unintended bets and poorly compensated risks. Constraints can prevent a value strategy from becoming too aggressive, or a quality fund from being overly conservative. The most common constraints include limits on:
- Turnover
- Tracking error to the starting universe
- Duration
- Credit risk
- Sector exposure
- Issuer weightings
How much credit- and interest-rate risk does the fund take?
There’s a good chance that funds that regularly deliver market-beating returns are taking greater risk than the market. While credit- and interest-rate risk tend to pay off over the long term, they don’t always. And it’s important to keep in mind that credit risk is positively correlated with equity risk, so funds that take greater credit risk may be less effective at diversifying equity risk.
To gauge duration and credit risk, it’s useful to compare the average duration of the fund’s holdings, as well as the distribution of their credit ratings, to a benchmark that can serve as a proxy for its starting universe.
Yield is also a good proxy for risk. This could be a fund’s SEC yield or the average option-adjusted spread of its holdings. If a bond is offering a high yield, it’s almost always indicative of some sort of risk; credit, duration, liquidity, or something else. Usually, the fund’s benchmark-relative yield will align with its relative credit- or interest-rate risk. If it does not, it’s necessary to do more digging.
A returns-based factor regression analysis can help paint a more complete picture of a fund’s credit- and interest-rate risk and whether it outperforms after controlling for those risks. This approach requires at least three years of monthly return data for the fund, or the index it tracks, preferably five. The model we use attempts to explain the fund’s excess returns, returns over the risk-free rate, as a function of its exposure to credit, duration, and residual market risk.
Look Under the Hood
There are no free lunches in the bond world--funds that consistently deliver market-beating returns almost certainly take greater risk. Risk is not necessarily bad. What’s important is that the fund is deliberate about the types of risks it takes, that it delivers its intended exposures in a cost-efficient manner, and that its approach to portfolio construction is grounded in sound economic rationale.
