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Smart Beta & Fixed Income: A Surprisingly Perfect Match


Smart Beta & Fixed Income: A Surprisingly Perfect Match

If the idea of combining smart beta and fixed income sounds a bit foreign to you, you’re not alone. Smart beta first became popularized in the equities market, largely because applying smart beta concepts to equities is quite straightforward. With plenty of readily available company and industry data, long track records, and broad time horizons, it’s not particularly difficult to select stocks using factors like size, value, momentum, volatility, and quality. Applying those same factors to the complex fixed income market, however, can be more than a little challenging. However, it is a challenge that can be overcome. By applying smart beta to fixed income, it’s possible to combine the investment alpha of active management to the structural alpha of an ETF—and gain the potential benefits of both.

Fixed income is a necessity for most investors, though today it can feel more like a necessary evil. Yields are historically low, and yet investing in fixed income is vital to meeting certain investment goals—from managing risk to seeking income to achieving longer-term risk-adjusted returns. It begs the question: is there a better way to invest in fixed income? My answer: absolutely.

As someone who has lived and breathed fixed income for more than a decade, I feel like I’ve seen the space from just about every angle there is. I’ve been immersed in the research. I’ve built and reviewed many models. What I’ve learned through observation and practical application is that the success of any given strategy is highly dependent on one thing: a data driven, objective, rules-based investment process. Historically, however, investment managers tend to shy away from rules-based processes when looking at fixed income. I can’t blame them. Unlike in equities where decisions are based on tangible data, identifying rules that apply to fixed income is not nearly so simple. Often viewed as fairly inefficient, the fixed income market is also highly complex. It lacks liquidity, it lacks information (at least compared to equities), and each type of fixed income product is subject to different risks.

Although fixed income benchmark indices exist and are widely followed, passive fixed income investing strategies that are based simply on debt amount outstanding have similar drawbacks as their equity peers. The reason: because debt amount outstanding has no correlation with a bond’s performance, this approach only gives investors exposure to the largest debtor—which is often not favorable. Even more challenging is the fact that, unlike equities, bond indices are designed to capture the broad market—including thousands of bonds that don’t trade everyday—so they are usually not tradable.

This is when smart beta comes to the rescue. While fixed income’s lack of liquidity, lack of information, and complex structure present challenges from an investor’s perspective, these characteristics create a valuable opportunity when it comes to creating a smart beta solution.

Related: Using Momentum in a Fixed Income ETF to Navigate an Uncertain Market

The first step is to translate well-established, fixed income investment principles into rules based on our understanding of what factors drive bond returns. Similar to factor investing in equities, we identify broad attributes that have been persistently shown to drive bond performance, and then weight security allocations based on the specific goal of the investor—better risk adjusted return, income generation, or risk mitigation. This approach to smart beta can offer all of the benefits—and potential for alpha—that come with active, rules-based management. When those benefits are contained in the tax- and cost-efficient wrapper of an ETF, the potential benefits are twofold.

At Index IQ, our smart beta fixed income ETFs are designed to deliver liquidity and a better adjusted rate of return—without subjecting the investor to greater risk. By rolling active management into a rules-based approach, we strive to remove the emotional bias that can be every investor’s greatest nemesis while also (and always) seeking better, more consistent long-term results. How do we do it?

  1. We begin by looking at the basic problem the investor is trying to solve. Are they seeking risk-adjusted return? Income? Risk mitigation?
  2. Next, we ask: How does the product design solve that problem? What are the drivers for risk and return? What rules can we use to select the most appropriate products for the investor’s need?
  3. Lastly, through execution and expertise, we seek ways to address liquidity.

The process is simple, but we believe portfolio design should not be rooted in a new, fancy quant model or a trendy marketing theme. Instead, we build from the basics, relying on the top-down and bottom-up data analysis that gives managers the information they need to make better, smarter investment decisions. Using our team’s quantitative background, we research and identify fundamental drivers and, ultimately, strive to deliver a solution that both fits into and supports the core portfolio, and delivers the benefits of smart beta across the fixed income universe.

Yes, I believe there is a better way to invest in fixed income. And I believe this is it.

Click here to learn more about IndexIQ.

IndexIQ® is the indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the IQ Hedge Multi-Strategy Plus Fund. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.
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