A:

Smart beta concepts and strategies are being used to create corporate bond funds with alternative rules for construction versus traditional bond indexes. These smart beta concepts seek to create different allocations of fixed-income securities in rules-based passive investment strategies. Although a majority of smart beta ETFs are focused on equities, new smart beta funds are coming to the market as of 2015.

Many traditional corporate bond indexes are weighted based on the amount of outstanding debt of the issuer. The issuers with the highest amount of debt, therefore, receive larger allocations. However, a company with more debt issued is not necessarily a better investment for fixed-income securities. Many fixed-income investors are more risk-averse than those who invest in other asset classes. Ironically, the bond index weighting toward amount of debt issued may actually increase the risk for this type of bond fund.

Smart beta strategies seek to build bond funds based on nontraditional index rules. These bond funds often have elements of passive index investing combined with active investing principles. These strategies seek to create a mix of fixed-income assets that have greater returns with lower volatility.

Equal Allocations for Risk

The two main risks when investing in bonds are credit risk, or the risk of a bond issuer defaulting on its obligations, and interest rate risk, or the risk interest rates move higher. Many traditional bond indexes are heavily weighted toward interest rate risk as opposed to credit risk. Some investors may wish to have a more equal allocation between credit risk and interest rate risk. In 2015, BlackRock launched a balanced-risk bond ETF to provide this type of product. Other smart beta funds have focused on allocation by sector, country of origin or bond duration.

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