The rise in smart-beta stock funds has begged the question: Why not smart-beta bond funds?
The answer may be that fundamental differences in the bond market may make smart-beta bond funds much more difficult to execute.
Smart beta is the buzzword for unmanaged funds that use specific rules — such as buying stocks of companies with a long history of raising dividends — to try to produce superior returns than traditional index funds. There are 620 smart-beta stock funds, according to Morningstar, and 23 fixed-income smart-beta funds.
The major problem is the complexity of the bond market. While it's relatively easy to buy Apple stock in large quantities, most companies have many different bond issues of various maturities, said Jeffrey Sherman, deputy chief investment officer at
DoubleLine.
“It's not like investing in an equity,” he said. For example, if a stock investor wanted to by Ford (F) stock, there's one common stock for the company. A bond investor who wanted to buy Ford Credit bonds would have dozens of issues from which to choose.
Another problem is liquidity, said Shane Shepherd, head of research at Research Affiliates. Bonds don't trade on a formal exchange, as stocks do.
“They are more difficult to trade, and that gives an advantage to active bond managers,” he said. “Active managers can see what trades and what doesn't.”
And from a practical viewpoint, the diffuse bond market makes it hard to write a rules-based program for trading.
Another problem with smart-beta bond funds is that the bond market usually doesn't have the volatility and returns that make a smart-beta approach worthwhile, Mr. Sherman said.
“Bonds are supposed to be slow-moving investments,” he said. “You don't see a bond go from 70 to 100 overnight.”
Just creating a bond index is tricky. It's fairly simple to create an index based on the market value of a company's stock, which is the most common way to create a stock index. But most bond investors would look askance at companies with the most amount of debt outstanding, or whose debt is rapidly rising. Adding factors to that index then become more problematic. Bond investors, for example, typically try to estimate an expected return after inflation, which means a best estimate on inflation as well as interest rates. They also have to make a best estimate on the company's credit outlook.
The few smart-beta bond funds with long-term track records haven't set the world afire. PowerShares Fundamental Investment Grade Corporate Bond ETF (PFIG), for example, offers a 2.6% yield and a 0.22% expense ratio. The fund tracks the RAFI Bonds US Investment Grade 1-10 Index — which considers a company's gross sales, gross dividends and cash flow, as well as the book value of the company's assets. The $63 million fund has returned an average 2.8% a year the past five years, according to Morningstar, placing it in the 87th percentile of the corporate bond category.
One fund that Morningstar identifies as smart beta,
PowerShares Emerging Markets Sovereign Debt Portfolio (PCY), has averaged 6.3% a year the past five years, versus 4.0% for the average emerging markets debt fund.
“Smart beta can work pretty well in high-yield bonds,” Mr. Shepherd said.
But he remains skeptical.
“I'm not sure that every concept is portable to another asset class,” Mr. Sherman said. “We're always open to ideas.”
