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For investors struggling to separate the trash from junk bonds, fund provider WisdomTree Investments Inc. swears by one simple test.

The New York-based manager of more than $38-billion (U.S.) in U.S. exchange-traded funds relies almost entirely on the ratio of a company's free cash flow versus equity to determine which bonds to buy through a new high-yield ETF. By deploying the strategy, Investors could avoid roughly 90 per cent of the speculative-grade debt that becomes distressed, the company's research shows.

It's the latest application of an investment style that has swept the world of equities while barely denting fixed income – smart beta. The idea is to tweak and tune passive investing vehicles in the hope of optimizing returns. WisdomTree, whose souped-up ETFs are some of the most popular in stocks, is using it to take aim at bond investors who are at once starved for yield but leery of rising default rates. "We see a lot of success on the equity side and that's resonating with people and I think, because of that, there is a growing interest in what could be done on the fixed-income side," said Nick Kalivas, a senior product strategist at Invesco Ltd.'s PowerShares ETF unit in Downers Grove, Ill.

Filtering the universe

Debt investors already have taken to ETFs, with $613-billion invested in bond-focused products as of June 30, compared with $461-billion a year earlier, according to BlackRock Inc. Now they're increasingly turning to smart beta, with a third of the debt ETFs started this year employing a version of the methodology.

Rather than track an index that weights its constituents by market value, smart-beta products filter the investment universe into different themes. Underlying indexes might skew toward securities deemed cheap, assets that offer exposure to rapidly expanding companies or those that are less volatile than their peers. BlackRock forecast in May that these funds will lure $2.4-trillion globally by 2025, up from $282-billion at the end of the first quarter.

In debt, WisdomTree's ETF arrives at a time when volatile commodity prices and signs of slowing global growth are taking a toll on Corporate America, pushing defaults among speculative-grade companies to 4.3 per cent last month, the highest since 2010, according to S&P Global Ratings. The firm sees the trailing 12-month rate climbing above 5 per cent within nine months.

Free cash flow

To help navigate that, the WisdomTree Fundamental U.S. High Yield Corporate Bond Fund tracks an index made up solely of high-yield debt issued by publicly traded companies that have a positive cash flow-to-equity ratio, using the five-year annual average.

"By far the factor that screams out the most is free cash flow," said Ambar Bajaj, a fixed-income analyst at WisdomTree. "The goal in high-yield is to avoid financial distress. You're already buying some bonds that are trading 70 cents on the dollar, maybe even 40 cents on the dollar; you just don't want them to get to 10 cents on the dollar or default."

As a precondition for index inclusion, each bond must have at least $500-million outstanding and be a year or more from maturity. The remaining universe of debt is then screened for liquidity using both the bond's size and its seasoning, with the least liquid 5 per cent of each industry excluded from the index. Weightings are determined by the probability of default and recovery-adjusted spread of the securities.

This method discards about 50 per cent of the high-yield bonds issued by public companies by market value, leaving the index with about 380 securities. The ETF seeks to track the index by holding a sample of it. The fund currently owns 47 bonds, its website shows.

Smart solution

Such ETFs are not, however, without their critics. Billionaire investors Carl Icahn and Howard Marks have both highlighted what they see as a mismatch between the liquidity of a bond ETF and its underlying assets. For smart beta, some see its customized weightings denting the purity of index-based investment, while others simply favour active over passive management, no matter how sophisticated.

It's been a volatile year for funds tracking the high-yield world. BlackRock's junk bond ETF, the largest of its kind, lost 4.8 per cent in the first six weeks of the year, then rebounded and now is returning 6.4 per cent. WisdomTree's product has gained 2.5 per cent since it began trading late April.

"Smart beta is the popular thing of the moment," said Matt Papazian, chief investment officer at Cardan Capital Partners in Denver, which owns about $7.6-million of a smart-beta junk ETF managed by PowerShares. Mr. Papazian bought that fund because it "mutes some of the volatility that comes from simply owning high-yield as an asset class."

PowerShares' high-yield fund uses measures of a company's cash flow, assets, sales and dividends to determine index composition. That ETF has about $920-million under management. BlackRock is looking to expand its offerings with products that could emphasize carry, interest-rate risk, inflation or the yield curve, according to Martin Small, who heads the company's U.S. ETF business.

"The longer rates stay where they are now," said Kevin Flanagan, senior fixed-income strategist at WisdomTree, "the more strategies like this are going to resonate."