The exchange-traded fund (ETF) market is evolving fast. Investors now have access to a range of passively managed products tracking indices that deliver active-like investment strategies. The market for ‘smart beta’ ETFs, defined by Morningstar as “strategic beta”, is growing substantially.
So far, the bulk of assets and product development have revolved around equity markets. In fact, ‘strategic beta’ and ‘equity factor investing’ have become synonymous. Meanwhile, assets in fixed income barely surpass 1 per cent of the total strategic beta ETF market and the number of products represents a small fraction of the overall offering. Why is this?
When it comes to strategic beta, equity is a much more straightforward proposition than fixed income. The equity market is a much simpler environment where there is a one-to-one relationship between a stock and the company it represents. By contrast, in the fixed income market any single entity – be it a government or a corporation – regularly issues a multitude of bonds with different characteristics (eg coupon, maturity, seniority) which determine differing patterns of behaviour. In addition, the equity market operates on-exchange with a single, consolidated pricing structure, whereas the fixed income market operates over-the-counter and feeds from a multiplicity of pricing sources.
The structural simplicity has also made it easier for academics to research the factors driving equity market performance (eg value, momentum, volatility). This, as well as the enormous leap in the technological capabilities of the indexing industry, has paved the way for the development of benchmarks that isolate these well-researched factors. It was then only a matter of time before these indices were wrapped in passive funds such as ETFs and offered to investors.
Despite the focus on equity, ETF providers have attempted to develop strategic beta products that exploit fixed income. The underlying idea has always been that market-cap weighting is not a rational way of investing, as investors become exposed to the most heavily indebted issuers, thereby assuming a great deal of risk. This is a simple marketing message that travels well. The reality of fixed income markets is, however, more nuanced.
Indeed, any index built solely on this basis is bound to be highly defensive in nature. And there are many instances when being defensive is not a rational approach. Take, for example, the eurozone sovereign debt market since mid-2012. Any shrewd investor should have opted to overweight peripheral – and the most heavily indebted – issuers in a bid to benefit from the upside afforded by the European Central Bank’s policy settings. Any index strategy biased to the safer issuers would have underperformed. Not smart.
Of late, ETF providers have fine-tuned the marketing message, focusing on the issuers’ abilities to pay rather than on their absolute levels of debt. The combination of both a quantitative and qualitative macroeconomic assessment to determine an issuer’s real chances of default provides a more coherent exposure. That said, these indices still retain a somewhat defensive tilt.
Jose Garcia-Zarate, senior ETF analyst, Morningstar
