(April 16, 2014) — Smart beta may be on the agenda for institutional investors across the world, but fixed income smart beta strategies have yet to take off.
Felix Goltz, head of applied research at EDHEC-Risk Institute, told aiCIO that while investors were keen to look at smart beta strategies for their fixed-income portfolios, most were left unimpressed by the current crop of offerings.
“There’s no clear consensus on the methodology to be used… [and] there are lots of investors who see the shortcomings of simply applying smart beta equity methodology to fixed income,” he said.
Managers which have developed fixed income smart beta indices tend to use methodologies developed for equity strategies, but investors “aren’t that convinced that it would work in the same way”, according to Goltz.
“Take minimum volatility: in equities the first effect is to lower the volatility of the index by focussing on low volatility and less risky stocks. But if you apply this to fixed income it makes much less sense—the low volatility approach would lead you to selecting lower volatility bonds, which would mean the portfolio would be heavily skewed towards short-term bonds from the least risky issuers – most likely the US, Australian or Norwegian gilts, given they issue ones that mature in six months,” Goltz explained.
Investors have been concerned about the lack of diversification within such a strategy, particularly given they can be skewed by what’s happening in the wider market.
“Look at when the all of the technology companies wanted to bid for the 4G networks in the UK: that meant billions was needed to finance that, which led to a flood of issued bonds from the tech sector,” Goltz said.
“Correlation modelling in equities is well established, but in fixed income it’s much more difficult.”
Despite this hesitance from investors, many managers have forged ahead and produced smart beta strategies for fixed income using the same methods they used for equities. Equal weighted strategies were cited by Goltz, along with fundamental ones where managers attempted to put screens over the indices including cash dividends, profits, and cash flow of the issuers.
“GDP has been used as an additional indicator on some, along with land mass, which is nonsensical—compare Singapore and Australia for example. The proponents then suggested using the square root of the land mass to get around it, but the bottom line is the methodology for smart beta fixed income is still very ad hoc,” he added.
Among the products already on the market are Research Affiliates’ corporate bond indices, which are weighted by the cash flow, sales, book value of assets, and dividends paid by issuers.
Different factors are used to weight the company’s indices for sovereign bonds—including gross domestic product, population, land area and energy consumption—to reflect the relative importance of different countries in the global economy.
BlackRock meanwhile has developed a “sovereign risk” index that incorporates factors such as a nation’s fiscal strength, external financing position, financial sector health, and measures of a country’s “willingness to pay”.
And PIMCO and Barclays both offer GDP-weighted bond indices.
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