A Factor Approach to Smart Beta Development in Fixed Income

Abstract

As index investing continues to grow, we are witnessing an expansion of what the beta continuum encompasses. Since the financial crisis, during which market-capitalization strategies have shown their limits, increasing attention is being devoted to index solutions that go beyond the traditional space—often referred to as smart beta. Since the publication of the first seminal papers in the early 1990s, equity investors have been aware of factors-based approaches reflecting systematic exposures to themes such as valuation, momentum, quality, or size. On the other hand, the progress on the fixed income side has been much slower and not until recently have investors started to investigate factors-based approaches with particular investment objectives. For this and other reasons, smart beta solutions in fixed income are likely to take a different shape than in equities. In this article, we discuss the concept of smart beta in fixed income. The first part describes the drawbacks of traditional benchmarks and analyzes the main factors driving fixed income returns. The second part presents a few examples of smart beta strategies providing exposure to the analyzed risk factors while addressing some of the benchmark issues.