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Voices: How rising rates can propel smart beta bond ETFs

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As the smart beta universe has experienced rapid growth, a common refrain among users of ETFs has been: “Where are the smart beta bond ETFs?”

Both in sheer population and assets under management, fixed-income funds currently represent a small percentage of the broader smart beta universe. An even smaller amount of smart beta bond ETFs have topped AUM milestones, such as $100 million or $1 billion. On the other hand, that could mean there is plenty of room for growth for fundamentally-weighted bond ETFs. Rising interest rates could be the catalyst to drive that growth.

“There is demand from investors for better diversified fixed-income indices, but the challenges in building smart beta strategies for bonds are much more nuanced than in equity markets,” Yazann Romahi, chief investment officer for quantitative beta strategies at JPMorgan Asset Management, told the Financial Times.

Cap-weighted bond funds, including ETFs, often track the Bloomberg Barclays US Aggregate Bond Index or a related benchmark. The problem with those indexes is that they are usually excessively allocated to Treasurys and mortgage-backed securities, a trait that can present interest rate vulnerability when interest rates rise. The Bloomberg Barclays US Aggregate Bond Index allocates nearly two-thirds of its combined weight to Treasurys or mortgage-backed securities.

Today, there are approximately 50 bond ETFs trading in the U.S. that meet the definition of smart beta. These funds use different strategies to manage interest rate and credit risk. Some smart beta bond funds will intentionally cap allocations to the more rate-sensitive corners of the bond market while others seek to manage duration above what is found in cap-weighted bond funds.

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In recent years, another idea popularized by ETF issuers is interest rate hedging. Rate-hedged ETFs often feature short positions in Treasurys in an effort to lower the overall portfolio's rate risk.

In other corners of the fixed-income space, smart beta bond ETFs are found focusing on higher quality high-yield issues or corporate governance and finances when it comes to corporate bonds.

“Traditional bond indexes are dominated by issuers with the most outstanding debt. Smart beta indexes reduce this risk by giving more weight to factors such as corporate cash flow or economic growth rates of countries,” according to Toroso Asset Management. “Some approaches more focused on returns also screen out bonds nearing their maturity date. ETF issuers hope smart beta indexes will draw investors worried that rising interest rates could reduce the returns on traditional bond funds.”