A new BlackRock Inc. fund being promoted as the money manager's first foray into bond-based “smart” beta is further blurring the hotly debated definition of a term that's driving advisers into exotic investment strategies.
The world's largest asset manager, which sells exchange-traded funds through its iShares unit, plans to launch a new fund Thursday that reengineers the traditional bond investing strategy to take more credit risk and less interest-rate risk, as investors anticipate the U.S. Federal Reserve tightening monetary policy by raising interest rates later this year.
BlackRock calls the iShares U.S. Fixed Income Balanced Risk ETF (INC) its first “smart” beta product, putting it squarely within a trend that's driving billions of dollars into ETFs.
BlackRock's push only adds complexity to that process for investors as the firm hopes to join brands like PowerShares, FlexShares and Research Affiliates in extending the popularity of the “smart” beta concept to bonds. Morningstar Inc. doesn't even see the fund as fitting its definition of “smart” beta, calling it active management instead.
The debate is heating up as advisers ask whether there are better ways to employ passive investing, particularly in a rising-rate environment, and as some look to reduce their exposure to active management for a number of reasons, including the departure last year of Pacific Investment Management Co. founder Bill Gross, who ran active strategies.
Unlike many other so-called “smart” beta products, INC is not technically registered as an “index” fund. It's labeled “active.” But the buy-and-sell decisions made by the portfolio manager, Scott Radell, and his team will be generated solely by a mathematical model, the firm has said.
The purpose is to achieve a roughly equal exposure to two sources of bond returns, interest-rate risk and credit risk. BlackRock contends that traditional bond funds that rely on indexes such as the Barclays Aggregate U.S. Bond Index are vulnerable to heightened risk when rates rise. Such an increase could happen as soon as midyear, according to Fed watchers.
“There is a pretty strong trend toward smart-beta products in the equity markets,” said Matthew Tucker, head of fixed-income strategy at iShares. “What we really haven't seen so far are very many products in the fixed-income market that represent smart beta.”
Matt DeLorenzo, fixed-income strategist for financial advisory firm United Asset Strategies Inc., said that in a normal, improving economy, credit spreads might tighten, giving a tailwind to the fund. But he said it might be different in today's environment if investors interpret rising rates as a negative development for corporate bonds, as they did during the “Taper Tantrum” in 2013.
“I don't think it's a good fit for us right now,” he said of the fund. “If the Fed raises rates and the market's not totally prepared for it, that could trigger some selling.”
As with all actively managed ETFs listed on U.S. exchanges, the fund will have to disclose its underlying holdings regularly. Yet while the fund is being promoted as “fully transparent” and “rules-based,” there is no index for investors to consult, and the rules that will determine the purchase and sale of underlying securities are not disclosed in the fund's prospectus.
“In this case, the transparency relates to the end product, which is the portfolio,” said Ben Johnson, director of passive funds research at Morningstar. “That's all fine and well, but I think from an investor's perspective, one would want greater transparency into the process as well.”
Mr. Johnson said, despite BlackRock's promotional materials, Morningstar does not consider the fund “strategic” beta, which is the researcher's preferred term for “smart” beta.
Further complicating matters, another research firm, ETF.com, provided a list of funds that iShares already runs that it considers “strategic,” including a series of dated bond strategies, called iBonds, as well as the iShares Global Inflation-Linked Bond (GTIP), the iShares International Inflation-Linked Bond (ITIP) and the iShares Yield Optimized Bond (BYLD).
In a statement, BlackRock said it considers iBonds a “bond-laddering” strategy, not smart beta. It said GTIP and ITIP were “not intended to be smart beta,” and that BYLD is “probably the closest” to smart beta, but that making an allocation to bonds based on their yield doesn't “necessarily” qualify as smart beta.
Regardless of the term, Mr. Johnson said investors should place the same level of due-diligence into examining the funds as they would traditional active strategies in order to understand, for instance, in what market environments a 50/50 split between credit and interest risk will succeed, and in which market such strategies will underperform.
In this case, the fund's exposure to Treasuries and high-yield debt, which varies from the Barclays Agg, could leave investors more exposed to credit risk even in cases when a rising-rate environment destabilizes those securities.
“I've certainly never heard of the attempt to make your interest-rate risk equal to your credit risk,” said Elisabeth Kashner, director of research at ETF.com. “On the face of it, I can't see anything wrong with it, but I'm not sure I can see anything right with it.”
Mr. Tucker said that while the fund is not for everybody, it is well-positioned to balance some of the risk on the credit side of the portfolio. He said the fund manager examined the bond markets broadly and found sectors that generated long-term, superior risk-adjusted returns: mortgage-backed securities, investment-grade corporate debt dated 1 to 10 years, and high-yield bonds rated “BB” and below.
“It's built around this idea that, yes, you're allocating to riskier sectors like high yield, but you're also keeping a level of interest-rate risk in there to balance out that risk,” he said.
To date, the term “smart” beta has largely been applied to index-based equity strategies that attempt to produce greater returns or reduce risks said to be embedded in traditional indexes. And they're often depicted as a cheaper, rules-based alternative to active management.