Smart-Beta is all the rage and for good measure. An illustration in a recent publication showed a Realized Risk Allocation of 90% to Interest Rate Risk in a widely used fixed income index, with the remaining 10% allocated to Credit Risk. The publication rightly contended that a Smart-Beta approach could level out the risk allocation to 50-50 and such diversification has resulted in better risk adjusted returns historically.
The ‘smart’ allocation described above might seem compelling in an environment of ‘not if but when’ trepidation around rate hikes. However, the strategy has implicit assumptions that are worth evaluating. Typically, the specter of a rate hike emerges with a strengthening economy and rising prices.
Such conditions translate to a benign credit environment manifested in tightening credit spreads. Such was the case in late 2012 and early 2013. Remember, the market fear during the ‘taper tantrum’? Rotating risk allocation from rates to credit would have made sense back then. But is the current environment similar?