Rules-Based Fixed Income ETF Investing. A Smarter Way to Access Bond Markets

Fixed Income exchange-traded funds (ETFs) can be used by investors to diversify, tactically adjust or build a core investment portfolio. However, there are several implementation and investment drawbacks associated with the traditional methodology applied to construct a passive fixed income index. Goldman Sachs Asset Management is on hand to discuss those.

Rules-based ETF investing seeks to solve for these challenges. It entails a simple, transparent process to define a liquid, investible universe which is then refined by fundamentals and rebalanced periodically. We believe this smarter approach can construct an enhanced passive fixed income index with a focus on improved risk-adjusted return potential over a market cycle.

Passive Investing: key drawbacks for Fixed Income Markets

Fixed income indices were established as a benchmark for active fixed income portfolios as an indication of market return. They were not however, established as a vehicle for direct investment.

Constructing a fixed income ETF based on traditional passive investment methodology—namely replicating existing bond index compositions—therefore entails key drawbacks from both an implementation standpoint and for potential risk-adjusted returns.

First, issuer weights for a traditional bond index are determined by market value of outstanding bonds. This leads to larger allocations to issuers with the most outstanding debt; an imperfect and potentially poor indicator of an issuer’s fundamentals and credit worthiness.

Second, the composition of an index can be based on credit ratings which tend to be revised after—rather than before—a change in fundamentals. The time lag between a credit rating change and the composition of an index could result in an investor being exposed to an issuer with an undesired credit profile for a period of time.

And third, it is not unusual for a bond index to contain thousands or even tens of thousands of bonds. Seeking to replicate these exposures can prove difficult due to low trading liquidity and costly given trading transaction costs.

Rules-based investing: a smarter approach to passive investing

A rules-based approach to passive fixed income investing seeks to address the drawbacks outlined above by first defining a liquid and investable investment universe; this can help to overcome transaction cost and liquidity challenges associated with seeking to minimize ETF tracking error relative to a pre-defined benchmark.

The next step is to apply a fundamental lens to screen and exclude certain bonds. Both the liquidity and fundamental screens are periodically reapplied to rebalance the index allocations.

The resultant index—which seeks a correlation with a pre-defined benchmark close to one—represents intelligent market beta with improved risk-adjusted return potential relative to a fixed income ETF developed through the traditional passive investing approach outlined above. This approach may also help to limit market drawdowns.

Avoiding the losers outweighs picking the winners

A fixed income investment tends to have an asymmetric potential return profile; upside potential is well-defined as it is based on timely coupon payments and a principal payment on maturity.

By contrast, downside potential is less well-defined and can be considerable in event of issuer default with limited or no recovery value. This means that avoiding ‘losers’ (namely poor performing bonds) can be more important from a potential risk-adjusted return standpoint than picking ‘winners’ (which can be defined as bonds with stable or improving performance) when compiling a passive fixed income index.

This asymmetric trait is why a fundamental lens is required for passive fixed income investing. By applying a fundamental screen, market beta can be accessed in a smarter and enhanced form.

Focus on the right fundamentals

Rigorous qualitative and quantitative analysis can help to identify a simple and transparent fundamental lens that can be applied to a particular fixed income sector. The metrics that a fundamental screen is based on should seek to provide both consistent and persistent insights into a bond issuer’s potential return and volatility characteristics. For example, the annual change in operating margins and leverage have been shown to be key drivers of subsequent bond performance within the investment grade corporate credit market.

In summary, replicating existing bond index compositions can be both inefficient—from a transaction cost perspective—and potentially unachievable due to liquidity challenges. Moreover, the asymmetric nature of a fixed income return profile informs the need for a fundamental lens.

A rules-based approach to fixed income passive investing can solve for these challenges and incorporate consideration for the asymmetric return profiles inherent in fixed income markets. The resultant index can provide investors with exposure to intelligent and enhanced market beta, with improved risk-adjusted return potential and in turn lower market drawdowns. This is a smarter way for passive investors to access fixed income markets.

Find out more about Rules-Based Fixed Income ETF Investing here.

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