One of the more pervasive recent investment trends has been the rise of smart beta. Such approaches aim to provide asset class exposure using a particular security selection and weighting scheme rather than traditional market-cap weighting. Smart beta advocates claim that investors can enjoy higher risk-adjusted returns.

While the investment community has focused on smart beta in equity markets, a smaller wave of smart-beta products focusing on corporate or government bond funds has also emerged. Recent experience, including the euro-zone sovereign debt crisis, the US government debt downgrade and the ongoing brinkmanship over US fiscal policy, has helped fuel the trend.

Proponents often argue that a rules-based process (other than price) can better identify credit-worthiness and therefore weight securities more fundamentally. The investor is therefore more intelligently invested and thus, in the eyes of its proponents anyway, smarter.

But is deviating from traditional market-cap weighting really going to deliver beta? Given that cap-weighted indices are ‘the market’ and represent the market beta, products that employ any alternative weighting schemes by definition constitute active bets against the market. That makes them active strategies pursuing alpha and not passive strategies delivering beta.

A careful examination of common examples of these strategies suggests that they behave more like active strategies than passive. They often lead to large exposures that differ greatly from the global bond market, frequently leaving investors exposed to bets they neither intend nor want.

“Years of empirical evidence do not show systematic links between levels of indebtedness and bond performance. Indeed, countries couldn’t issue debt if the market wasn’t willing to buy it. To the extent that some debt is deemed more risky, its price will be lower and, all things being equal, its weighting in the index will fall”

Like all active bets, they will not always outperform their market-cap-weighted counterparts. During these periods, investors may succumb to common behavioural pitfalls and bail out, rather than sticking with strategies that don’t deliver the returns they have been led to expect. Furthermore, as with all investment trends, investors may be tempted to chase recent performance or the latest hot investing trend. History suggests that jumping onto fads is not a recipe for sustained investment success.

Critics of market-cap indices point out that they are heavily exposed to bonds issued by the world’s largest, and presumably riskiest, debtors. While it’s true that high-debt countries like the US, Italy or Japan issue vast quantities of public debt and therefore occupy large weightings in market-cap indices, it does not necessarily follow that investing heavily in these markets is inherently more risky.

Debating points 

• Smart beta looks more like alpha.
• Large-scale debt issuers are not necessarily high-risk.
• Bonds’ diversification properties could be lost in a smart-beta product.

Years of empirical evidence do not show systematic links between levels of indebtedness and bond performance. Indeed, countries couldn’t issue debt if the market wasn’t willing to buy it. The totality of the investor community assigns a price to such debt and reflects investors’ collective assessment of the issuer’s riskiness. To the extent that some debt is deemed more risky, its price will be lower and, all things being equal, its weighting in the index will fall. 

A number of smart-beta bond strategies use GDP, population, or (somewhat enigmatically) landmass, as weighting schemes, which can lead to some significant sector overweights. One wonders what possible investment case these schemes make for such overweights. For example, many smart-beta strategies result in overweight positions in emerging market debt. A systematic overweight to emerging market debt is a strategic choice, the merits of which are worth debating. But why not just overweight emerging debt outright if that’s what an investor thinks would be a winning strategy? Why use a rule that may or may not have sound investment logic?

Furthermore, overweighting a sub-asset class or a risk factor can often result in concentrations that can boomerang during periods of market volatility. For example, this past summer’s Fed taper scare led a large retreat in emerging market debt. Those losses had little to do with credit metrics or economic fundamentals. They certainly didn’t have anything to do with population or landmass.

“So-called smart-beta bond indices are therefore not always smart, nor do they provide market beta. Some may be nothing more than marketing stories emerging from an evolving fad. In other cases, they are active strategies by another name”

On the premise that fixed-income investing is not necessarily about return-chasing, but rather providing diversification to ‘risk’ assets (such as equities) in balanced portfolios, smart beta strategies can lead to less diversification just when a portfolio needs it most. In periods of equity volatility, the correlation of emerging market debt with global equities can rise. Smart-beta investors who think they are well diversified thanks to their bond holdings may find themselves more concentrated in equity-like risk than they intended. It is not clear that investors buying into the smart-beta story necessarily understand these risks.

So-called smart-beta bond indices are therefore not always smart, nor do they provide market beta. Some may be nothing more than marketing stories emerging from an evolving fad. In other cases, they are active strategies by another name, rather than broad market beta at all. They offer risk profiles that can differ widely from portfolios based on the total market for investable bonds.

The investment merits of these strategies are legitimately debatable, but so is investors’ understanding of the risks. To avoid unpredictable outcomes, investors may want to ask why they are choosing a particular strategy and not the market, including what they may be giving up and what unseen bets they may be taking if they adopt a smart-beta strategy.

John Velis is an investment analyst at Vanguard Asset Management