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ETF Specialist

This Strategic-Beta Bond Fund Pulls From the Active-Manager Playbook

This fund boosts yield by upping credit risk relative to the Aggregate Index.

It’s no secret among active bond managers that the conservative nature of the Bloomberg Barclays U.S. Aggregate Bond Index makes it an easy benchmark to top. More than 70% of the index is invested in AAA rated bonds. Many actively managed bond funds outperform the Aggregate Index by taking on more risk.  WisdomTree Yield Enhanced U.S. Aggregate Bond ETF (AGGY) is a strategic-beta fund that strives to boost return by overweighting higher-yielding components of the Aggregate Index. This fund doesn’t take outsize risk, and it could serve as inexpensive core bond holding. The fund’s low fee and reasonable investment process support its Morningstar Analyst Rating of Bronze.

The fund tracks the Bloomberg Barclays U.S. Aggregate Enhanced Yield Index, which divides the investment-grade-focused Aggregate Index into 20 subcomponents. The index defines these subcomponents by sector (securitized, corporate credit, and government), years to maturity, and credit rating. Each month, the fund reweights these subsectors to maximize the portfolio’s yield under a set of constraints to limit turnover, preserve diversification, and limit risk. For example, most of the fund’s subsector weightings stay within 10% of the Aggregate Index, and it caps monthly tracking error against its parent index.

The strategy offers higher yield by tilting toward corporate bonds and away from U.S. Treasuries relative to the Aggregate Index. Although it takes greater credit risk than its parent benchmark, this risk is moderate and is more representative of how active managers in the intermediate-term bond Morningstar Category invest. As of this writing, the fund allocates half of its portfolio to corporate bonds compared with 30% for the Aggregate Index. Conversely, its Treasury weighting measures about 20% of the portfolio compared with the Aggregate Index's 40%. Securitized assets make up the remaining portion of the fund’s holdings, in line with the Aggregate Index's weighting. The fund’s duration of 6.8 years as of this writing is near the duration of the Aggregate Index.

So far, this strategy has paid off. From its inception in July 2015 through November 2018, its return topped the category average by 0.27% annually, albeit with greater risk. The fund’s tilt toward corporate bonds contributed the most to its outperformance.

Fundamental View
Bonds’ risk and return are closely linked. The Aggregate Index's conservative nature makes it easy to top. More than 70% of the index is invested in AAA rated bonds. Many actively managed bond funds outperform the Aggregate Index by taking on more risk.

This fund pulls from the active-manager playbook and systematically takes more credit risk than its parent index, the Aggregate Index, in an attempt to deliver higher returns. It does this by reweighting the components of the Aggregate Index to emphasize the higher-yielding areas of the investment-grade market. The fund has guardrails in place so it doesn’t take an unreasonable amount of risk.

The fund’s primary risk dampener is its monthly tracking error limit of 0.35% versus the Aggregate Index. Over the past three years through November 2018, the fund’s annualized tracking error versus the Aggregate Index measured 1.0%. This figure registers as a medium level of active risk and indicates that the fund’s performance relative to the Aggregate Index shouldn’t deviate too far in either direction. The fund also reins in risk by limiting sector bets to plus or minus 20% at each monthly rebalance and capping its duration to one year longer than the duration of the Aggregate Index. As of November 2018, the strategy’s duration measured 6.8, about one year longer than the Aggregate Index’s.

The fund primarily finds more yield from credit rather than interest-rate risk, which gives it exposure to credit spread risk. Credit spreads usually widen when business conditions worsen, and bond investors require more potential return (yield) to compensate them for the perceived increase in default risk. When credit spreads widen, lower-quality investment-grade bonds tend to underperform safer Treasuries. Conversely, narrowing credit spreads give lower-quality bonds a boost. The lower the bond’s credit quality, the more sensitive it is to changes in credit spreads. At the end of November 2018, the portfolio's BBB exposure measured more than a fourth of its assets, compared with about a fifth of assets for the average category peer. BBB rated bonds make up about 10% of the Aggregate Index’s portfolio.

The fund’s bet on credit risk influences its performance. The 10-year credit spread of BBB bonds widened from 1.56% in February 2018 to 2.27% at the end of November 2018. Not surprising, this fund lagged the Aggregate Index by 1.6 percentage points over that period. Conversely, when the 10-year credit spread of BBB rated bonds tightened from 3.55% in March 2016 to 1.56% at the end of January 2018, the fund outpaced the performance of the Aggregate Index by 1.8% annualized.

Portfolio Construction
This fund takes reasonable steps to boost yield, without taking excessive risk and keeps turnover under control. It warrants a Positive Process Pillar rating.

This broad portfolio is arguably more representative of how active managers in the category invest than the market-cap-weighted Aggregate Index. The fund uses representative sampling to track the Bloomberg Barclays U.S. Aggregate Enhanced Yield Index. This strategy divides the Aggregate Index into 20 subcomponents based on different risk dimensions, including sector exposure, interest-rate risk, and credit risk. In total, six of these buckets cover Treasury and agency debt, nine cover corporate debt, and five cover securitized debt. The fund then reweights them to maximize yield under a set of constraints. These include limiting tracking error relative to the Aggregate Index, keeping sector weightings within 20% of that index and preventing duration from extending beyond a year longer than the index. It also limits turnover each month. Eligible securities include U.S.-dollar-denominated investment-grade bonds with at least $300 million in par outstanding. Asset-backed and commercial mortgage-backed bonds have different liquidity requirements. Yield to worst is the primary measure for calculating expected yields.

Fees
WisdomTree charges a low fee of 0.12% for this fund, which offers a durable edge and supports its Positive Price Pillar rating. In fact, this fund's fee lands in the cheapest decile of the intermediate-term bond category.

Over the trailing three years through November 2018, the fund lagged its index by 24 basis points annually. This was slightly more than the amount of its expense ratio, owing to transaction costs and modest sampling error.

Alternatives
Nushares Enhanced Yield U.S. Aggregate Bond ETF (NUAG) (0.20% fee) is AGGY’s closest peer. This fund breaks up the ICE BofA Merrill Lynch U.S. Broad Market Index into 38 components and reweights them monthly to fund yield subject the risk constraints. Like AGGY, the fund takes more credit risk than its parent benchmark, which largely overlaps with the Aggregate Index.

There are several Silver-rated, low-cost funds that track the market-cap-weighted Aggregate Index. These funds include  Schwab U.S. Aggregate Bond ETF (SCHZ) (0.04% fee),  SPDR Portfolio Aggregate Bond ETF (SPAB) (0.04% fee), and  iShares Core U.S. Aggregate Bond ETF (AGG) (0.05% fee).

 Vanguard Total Bond Market ETF (BND) (0.05% fee) tracks a float-adjusted version of the Aggregate Index. This index excludes securities held by the Federal Reserve from its weighting calculations. As of this writing, however, the composition is similar to the Aggregate Index.

Silver-rated  iShares Core Total USD Bond Market ETF (IUSB) (0.06% fee) provides market-cap-weighted exposure to the entire U.S.-dollar-denominated bond market, including bonds across the full credit spectrum. However, investment-grade bonds represent more than 90% of the portfolio. So, despite its inclusion of high-yield bonds, IUSB tends to take a little less credit risk than AGGY.

 

 

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Adam McCullough does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.