Today I want to revisit a topic I have touched on a few times: smart beta and fixed income. Here at BlackRock we love to throw around terms like macro factors, style factors and diversification. Geek speak. Let’s face it: I work in a geeky place, and we’re not that different from our tech neighbors here in San Francisco.
This shared geekiness extends to what we produce as well. A smartphone today is still a phone, but it’s also a camera, navigator, wallet, music player, game console and more. It is an entirely new way to think about personal electronics. A smart beta bond fund is still an index fund, and still made up of bonds, but it is also an entirely new way to think about bond investing.
Usually when someone invests in the bond market, they buy a specific type of bond, like a corporate bond. The investment is usually thought of in terms of what it is: an industrial bond, a consumer issuer, etc. These classifications do matter, but in some ways they matter less than how a bond performs once you buy it.
Factor investing takes a different, smart approach. It looks at the market in terms of what specifically drives bond performance. For example, if I own a Treasury bond, something I should care about is my exposure to interest rate risk because it determines how my bond performs. And if I hold a corporate bond, there are both interest rate risk and credit risk to worry about.
This factor reframing lets us look at portfolio characteristics differently. Instead of the weights of different types of bonds, investors can hone in on exposure to factors that drive portfolio performance, such as interest rate risk, credit risk, and others. It changes the conversation from “I have this much government bonds and this much corporate bonds” to “I have this much exposure to changes in interest rates, and this much exposure to credit markets”. More importantly, this reframing can be used to build a portfolio in a new way: combining specific factors to create smart portfolios that target specific investment outcomes.
The making of a bond machine
Based on this factor approach, we created iShares Edge U.S. Fixed Income Balanced Risk ETF (FIBR) three years ago. FIBR is an index fund that is benchmarked to the Bloomberg Barclays U.S. Fixed Income Balanced Risk Index. The trick is that the index is built to target a specific ratio of factor exposures: a 50/50 mix between interest rate risk and credit risk. The “broad market” in fixed income is typically measured by the Bloomberg Barclays U.S. Aggregate Index (Bloomberg Barclays Aggregate), which is market-cap weighted and has historically had an approximately 90/10 split between interest rate risk and credit risk. Compared to the Bloomberg Barclays Aggregate, the Balanced Risk Index aims to diversify the sources of risk and return, which has resulted in a tilt towards generating income and a more defensive (lower) duration.
But that is the geeky explanation. Most investors really just care about what FIBR does for their portfolio. FIBR systematically incorporates strategies used in traditional active portfolios. For example, FIBR invests only in asset classes that have historically had high risk-adjusted returns . And FIBR tilts towards higher yielding asset classes and securities. These traditional active strategies are just wrapped up into an index and implemented consistently through time in an ETF. Oh, and it’s offered at a net fee of 25 basis points1, which is lower than 95% of the funds in the Morningstar Intermediate Term Bond category (source: Morningstar as of 3/15/2018).
Man vs. machine
When FIBR was first introduced, there was much talk about “man vs. machine.” How would a factor-driven, rules-based ETF perform relative to traditional intermediate term bond managers? Now that we have three years of return history, we can take a look at the results. Over the three-year period ending February 28, 2018, FIBR was ranked #65 out of 837 funds in the intermediate term bond category, meaning it outperformed 92% of its peers (source: Morningstar, from 2/28/2015 to 2/28/2018). FIBR was awarded 5 out of 5 stars by Morningstar for its 3-year performance.2
See how related fixed income strategies performed relative to each other in the chart below.
Thus far, it appears that the machine is delivering. The key takeaway here for investors is that FIBR offers a new alternative for core bond investing. One that incorporates many traditional active strategies into a diversified portfolio, and delivers them in a low-cost ETF wrapper. Not bad for a little machine. Just like your smartphone.
1. The gross expense ratios is 26 basis points. BlackRock Fund Advisors (“BFA”), the investment adviser to the Fund and an affiliate of BlackRock Investments, LLC, has contractually agreed to waive a portion of its management fees through February 29, 2024. Please see the Fund’s prospectus for more information.
2. Source: Morningstar, as of 2/28/2018. Morningstar ratings based on risk-adjusted returns. Past performance does not guarantee future results. For each U.S.-domiciled fund with at least a 3-year history, Morningstar calculates a Morningstar Rating™ based on a Morningstar Risk-Adjusted Return measure that accounts for variations in a fund’s monthly performance (including loads and redemption fees), placing more emphasis on downward variations and rewarding consistent performance. The top 10% of funds receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars and the bottom 10% receive 1 star. (Each share class is counted as a fraction of one fund within this scale and rated separately, which may cause slight variations in the distribution percentages.) The Overall Morningstar Rating for a fund is derived from a weighted-average of the performance figures associated with its 3-, 5- and 10-year (if applicable) Morningstar Rating metrics. The Fund received a rating of 5 stars for the 3-year period, rated against 837 Intermediate-Term Bond funds. For standardized performance click here.