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Exploiting the rule-based investor

Craving for ETFs boosts European appetite for equity funds

Growth in inefficient investments

In recent years investor attention has been focused on index-tracking given the dramatic growth of flows into exchange-traded products (ETPs) and funds (ETFs).
The majority of these flows have been into familiar benchmark-weighted ETFs based on traditional indices, which for a fixed-income investor means an index likely to be flawed in its construction. This does not automatically equate to a bad investment but as active managers we regard building, then managing a strategy based on market-cap weighting rather than intrinsic value or opportunity to be inefficient.

(5. The hidden risk in debt benchmarks)

Furthermore rules-based investing may force action that is not rational, creating stampede and crowding effects without consideration of the investment opportunities.

The rise of smart beta

As always, any index-based investment strategy is there to evolve and be developed. There has been considerable evolution towards smart beta which is often perceived to be a passive strategy with a clearly defined, rules-based approach (i.e. not simply cap weighted) exploiting specific factors, such as style or systematic anomaly.
Smart-equity beta is arguably an easier concept to define than fixed-income smart beta as equities have the same structural characteristics as each other and can be evaluated based on financial information or technical factors which can easily be replicated. Equally, ‘model’ replication is operationally simpler and on average less costly.

Smart-beta issues in fixed income

Smart beta does not work easily in many fixed-income markets for several reasons. First, ‘smart’ fixed-income strategies are not well defined. Securities often come ready segmented by credit rating and complexities such as duration and optionality make it difficult to differentiate between what is smart and what is simply beta.

Second, rules-based approaches are fraught with operational pitfalls. Credit markets, for example, are typically less liquid with more costly trading than their equity peers. Replication of rules-based strategies can be complicated by market liquidity.

Paying away the bid/offer spreads to rebalance portfolios in line with a rules-based approach can negatively impact returns, while slippage from the rules may compromise the integrity of the process.

Active management can help

However, we do think it is possible to have a smart-beta concept in fixed income, as long as active management is used to overcome some of the problems outlined. In our view, the big drivers of pure beta are duration and credit quality, and to a lesser extent sectors and geographies.

These are the main systematic factors investors are really allocating to when making their decisions. Our approach is to use the relative value model as a systematic smart-beta screen for value, specifically looking for undervalued bonds with the potential to mean revert to levels consistent with their beta.

Active management bridges the operational problems of strict rules-based portfolio construction and credit analysis and tries to enhance selection further to generate returns. We would characterize our approach a ‘value’ style or ‘smart factor’.

Other styles might include ‘growth’, which looks for upgrade candidates; ‘fallen angels’ which invests in downgraded securities; or ‘strong horse’, which invests in companies that meet specific financial criteria. We believe this value approach has a number of key advantages and is adaptable to many investors’ appetite for beta.
Links to fund pages

Further reading

For more information on the relationship between duration and relative value, read our whitepaper A Theory of Relativity.

Part of the Bonhill Group.