Mar 26, 2015 - Sara Shores
When you think about a smart beta investment strategy, you probably think about equities. Many investors have become familiar with the notion of capturing historically rewarded factors, such as value, quality, or low volatility, in their stock portfolios. In essence, smart beta strategies seek to re-write index rules to capture these factors. What some investors may not know is that this way of thinking can be applied to bond portfolios. How? Let’s take a look at the market dynamics in fixed income.
Different risk profiles
The first thing to keep in mind is that the nature of fixed income makes the return payout asymmetrical. The best a bond can do is pay its coupons and return its par value; however the worst it can do is default and leave you with $0. As a result a lot of the value that can be generated in fixed income is about loss avoidance, and about managing risk over time.
Equity markets are predominately characterized by stock specific risk. For example, you will likely have a very different return experience investing in Citigroup versus Apple. In contrast, fixed income markets have far less security-specific risk. In fact, the total return for core bond portfolios is governed predominately by exposures to two macro-economic risk factors: interest rate risk and credit risk. As my colleague Matt Tucker wrote in a recent post, core fixed income benchmarks like the Barclays US Aggregate are dominated by interest rate risk, and in the current market environment, investors are not paid very much to take on that risk.
But how should an investor manage these macro-economic exposures in their bond portfolio? The allocation decision between interest rate and credit exposure will have a significantly larger impact on the investment outcome than would any security-specific decisions. BlackRock’s first fixed income smart beta ETF, iShares US Fixed Income Balanced Risk (INC), factors in this dynamic and seeks to generate income through a diversified portfolio that balances the primary components of returns – interest rate and credit risk.
Investor behavior creates opportunity
When it comes to both stocks and bonds, market inefficiencies can be driven by powerful forces like investor behavior and structural impediments. Some of these phenomena are similar across equities and fixed income: many investors are averse to leverage and therefore gravitate to riskier stocks in their search for high returns, which can lead to over-buying of higher volatility stocks.*. That same leverage aversion exists among fixed income investors – longer duration bonds may be over-priced on a risk-adjusted basis compared to similar bonds of a shorter maturity (Barclays). Other inefficiencies are unique to bond markets: commonly used benchmarks like the Barclays Aggregate only include investment grade securities, and as a result some investors add exposure to sectors such as high yield or emerging market debt to help boost yield.
All of the above phenomena are well known by fixed income managers (and have been the fodder of active fixed income strategies for decades) but have not been arbitraged away precisely because of the barriers presented by these behavioral or structural market forces. Fixed income smart beta funds, such as INC, seek to capture these inefficiencies in a rules based and transparent manner.
So what’s next?
With plenty of opportunities for smart beta strategies in fixed income, you may wonder why so few smart beta bond strategies exist. Well, as I predicted in my New Year’s post, this is an area where I expect we’ll see a significant amount of development and innovation in the future. INC is BlackRock’s first important step into that exciting frontier.
* R. Clarke, H. Silva and S. Thorley, ”Minimum-Variance Portfolios in the U. S. Equity Market,” Journal of Portfolio Management, 2006.
Sara Shores is Global Head of Smart Beta for BlackRock. You can read more of her posts here.
Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.
Investing involves risk, including possible loss of principal.
The iShares U.S. Fixed Income Balanced Risk ETF is actively managed and does not seek to replicate the performance of a specified index. The Fund may have a higher portfolio turnover than funds that seek to replicate the performance of an index.
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities. INC’s use of derivatives may reduce the Fund’s returns and/or increase volatility and subject the Fund to counterparty risk, which is the risk that the other party in the transaction will not fulfill its contractual obligation. The Fund could suffer losses related to its derivative positions because of a possible lack of liquidity in the secondary market and as a result of unanticipated market movements, which losses are potentially unlimited. There can be no assurance that the Fund’s hedging transactions will be effective.
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