Fidelity hedges the Fed by expanding into factor-based bond ETFs

With the Federal Reserve inching interest rates higher, more creativity will be called for fixed-income allocations, which is the wave Fidelity Investments is hoping to catch with two new factor-based strategies. Rolling out low-cost factor-based exchange-traded funds in the middle of a rising-rate cycle is just good business, according to Todd Rosenbluth, senior director of ETF and mutual fund research at CFRA. "Unless something drastic happens, 2018 will be the year when the average actively-managed bond mutual fund declines in value," he said. "As investors start to notice that, they will pay even closer attention to the fees they're paying." The two new funds, Fidelity Low Duration Bond Factor ETF (FDLR) and Fidelity High Yield Factor ETF (FDHY), join Fidelity's eight equity-based factor ETFs. The expansion into the fixed-income space, which is rare among factor strategies, is about addressing investor demand, according to Greg Friedman, head of ETF strategies at Fidelity. "Clients have been clamoring for smart beta on fixed income side, and this is an evolution of the product set," he said. Factor-based investing is a subset of smart beta, which deviates from traditional market-cap-weighted index investing. While pure index-based investing offers exposure to a basket of securities, and active management is designed to generate returns above an index, smart beta and factor-based strategies target particular outcomes and exposures. For example, Fidelity's low-duration ETF blends debt instruments with durations of five years or less with 7-to-10-year Treasury bonds to create a low-duration fund with extra yield. The high-yield factor ETF applies a quantitative screen for a portfolio foundation of bonds that is capped with an actively-managed strategy to reduce the impact on the otherwise sensitive high-yield market. In addition to helping investors and financial advisers navigate a rising-rate cycle, Mr. Rosenbluth said the factor ETFs will gain appeal with fees of 15 basis points for the low-duration fund and 45 basis points for the high-yield fund. For comparison, consider that the average high-yield bond mutual fund has an expense ratio of 1.1%.