The new year has started, but the financial markets are still affected by topics from the old year. One of the topics that has come up again is the liquidity of bonds in general—and bond funds in particular. From my point of view nearly all that can be said has been said about this topic. After all this discussion about liquidity in the bond markets and the possible implications for bond funds, especially exchange-traded funds (ETFs), one might raise the question of whether these issues could be addressed with smart-beta products. These products concentrate on the liquidity of securities in addition to using the two main drivers of performance–duration and credit risk.
Since the liquidity of the underlying securities is already an issue for ETFs that track the broad indices, even “plain-vanilla” products are nowadays not far from being smart-beta products. That is because of the optimization techniques used to replicate the returns of the underlying index using the tradable securities in the index basket. In this regard a smart-beta strategy that employs the liquidity of the bonds would help to build liquid indices for all kinds of bond sectors, which could then easily be replicated by funds.
In addition, a smart-beta approach could help investors overcome the major struggle of market-weighted bond indices: these indices give the highest weightings to issuers (companies, countries, etc.) with the highest outstanding debt in the respective investment universe. This approach can lead to high single-issuer risk within the portfolio, which is normally not the intention of an investor who buys into a broad market index. A smart-beta approach could limit the issuer risk by introducing a cap within the index methodology.
From my point of view smart-beta ETFs could be the answer to the questions and concerns raised by investors around bond indices. Since investors tend to buy only products they understand, the index construction must be quite smart. At the same time it must be as simple as possible, so investors can easily understand the investment objective and the risk/return profile of the index and therefore of the ETF. That said, in my opinion it is time for smart beta to enter the bond markets.
The views expressed are the views of the author, not necessarily those of Thomson Reuters.