Research is indicating factors are the driver for bond fund manager outperformance, even outside of factor investing mandates. By Lynn Strongin Dodds
Factor investing has gained momentum in the equity space and it was only a matter of time before it infiltrated the fixed income market. However, a recent study by Invesco argues that these quantitative characteristics are among the main reasons why active bond managers recently outshone their equity counterparts and as a result, should be incorporated regardless of the packaging.
The numbers crunched by Invesco showed that factors explained 66% of a bond manager’s outperformance over the past decade. It was based on a sample of 65 US investment managers representing the largest players in the Lipper Core Plus peer group over the period from January 1, 2007, to June 30, 2018. The factors studied excess returns from value – bonds priced lower than their peers; carry or higher-yielding bonds and liquidity which holds fewer liquid bonds. Also in the mix was quality which recognises the return benefits of holding low volatility bonds.
Invesco research offers credence to often quoted studies such as Morningstar’s 2018 mid-year report, which tracks active and passive performance across US equity and bond funds. It revealed that, while only 36% of active equity managers beat their passive benchmarks over the trailing one, three, five and 10-year periods ending in June 2018, over 70% of bond fund managers surpassed their passive indices.
According to Stephen Quance, director of factor investing at Invesco, the median manager was exposed to carry, liquidity and value, and that the majority of bond managers were able to beat their benchmarks, at least partially, by holding older, smaller issue size bonds with lower ratings and longer maturities compared to the benchmark average.
“What we were trying to do was explain factor investing against the broader discussions taking place in the market and where it sits in the ecosystem,” he adds. “There is a lot of confusion about terminology and words that are used interchangeably. Our findings show that factors matter whether you have a factor approach or not and this in turn should help investors better understand the role factors play in their bond portfolios. It can help them choose the right approach and manage which factors they want to have exposure too.”
For example, bond managers could opt to slot in a single-factor solution such as quality to balance the natural carry and value tilts of the median active manager. However, as the study points out investors are advised not to go down that route because single factors can experience long periods of outperformance and underperformance relative to the benchmark. “A multi-factor solution may be more desirable where investors are seeking long-term exposure to all factor premiums in an efficient and risk-controlled manner,” it says.
Invesco is not alone in its findings. “Academic research confirms that factor exposures, either explicit or implicit, explain the majority of outperformance of active managers,” says Patrick Houweling, lead portfolio manager and researcher Quant Credits at Robeco which has done its own analysis. “We found that factor credit strategies in investment grade and high yield, that have balanced and intentional exposure to factors, correlate negatively in terms of their relative performances with fundamentally managed credit and high yield funds that have less structural exposure to factors,” he adds. “This means that adding a factor credit allocation to fundamentally managed credits improves diversification.”
There are of course other drivers behind the returns of active managers. A separate paper from AQR – The Illusion of Fixed Income Alpha – states that many simply outperform the index by increasing exposure to riskier parts of the market, such as high yield and emerging markets, which tend not to be included in the traditional market cap weighted indices. Take the popular Bloomberg Barclays index. It still represents less than half of the total fixed income world, excluding about $21 trillion of investible securities. These include many attractive bond structures, such as non-agency commercial and residential mortgage backed securities, CMO obligations and all floating rate issues.
Moreover, as companies issue more debt, their representation actually increases. This results in passive investors having the largest exposure to the most indebted companies, which many argue is the opposite of a sound investment strategy.
For its study, AQR looked at three categories using the eVestment database: US Aggregate, which included 445 core and core plus managers, Global Aggregate – 44 managers, and Global Unconstrained Bond funds, a sphere of 114 managers.
“We would say credit exposure, which we characterise as market exposure, or beta, can help explain much of a fund manager’s outperformance,” says Tony Gould, a managing director at AQR Capital Management. “Many take more credit risk than the benchmark and, for example, go overweight triple Bs, which are at the lower quality end of the investable universe.”
Fundamental research should also not be underestimated, according to Sebastiaan Reinders, portfolio manager global high yield and US high yield at NN Investment Partners. He believes that factor investing should be complementary to other investment styles.
“The low, or at periods negative, correlation of factor-alpha with other investment strategies is one of the reasons why we incorporate insights from factor research in our high yield strategies, so that we get the best of both man and machine,” he adds. “I think that being aware of the factor exposures that an investment strategy has is very important, especially when it helps identifying implicit top down positioning, similar as how you would measure country, sector, or rating exposures.”
Reinders adds though that for an inefficient, opaque and not so liquid asset class like high yield, factor exposures matter but that there also needs to be an understanding of the fundamental credit story in order to achieve outperformance.
“Bottom up credit research by our analyst team has been a critical success factor,” he says. “By speaking with management teams, understanding their business and strategy, and performing our own unbiased stress-testing of their capital structures, we are able to understand what drives the improvement or deterioration of a company’s credit profile. By applying our industry knowledge and looking at relative value with comparable investment opportunities we identify the mispriced securities and capitalise on that, this is the starting point for our portfolio construction.”
Grégory Taïeb, an investment specialist within the Multi-Asset, Quantitative and Solutions investment group (MAQS) at BNP Paribas Asset Management also stresses the importance of quantitative research. He adds that the team looks at the financial strength of a company, such as cashflows and profitability among others factors, to determine the likelihood of its defaulting, which is a source of negative returns. “We hedge top down risks such as spread and duration, and systematically use our bottom up/security selection investment approach in order to deliver regular outperformance. At the same time we control portfolio risk – volatility and duration times spread – as much as possible.”
While market participants expect managers to increasingly integrate factors into their portfolio construction, they also believe that specific factor-based or smart beta products will enter the market. Their evolution will be slower than equities which still dominate. In Europe alone, smart beta equity ETFs -which are a popular vehicle for the strategy – account for roughly two thirds of the total €760bn of assets under management reported to Morningstar at the end of first-quarter 2019.
The main hurdles are the OTC nature of the market as well as lack of data and academic insights.
“Data on equities goes back to 1926 and the high-quality data Fama and French used in their model (which explains the impact of factors on equities) dates back to the 1960s,” says Gould. “This is not the case with fixed income. For example, TRACE (The Trade Reporting and Compliance Engine) did not start until 2002, and didn’t originally cover the whole U.S. bond market, just corporate bonds. That means there wasn’t enough data for building and testing models until earlier this decade.”
However, as Invesco’s third annual Global Factor Investing Study (published in 2018) shows fixed income is definitely on the smart beta or factor agenda. Slightly more than half of institutional investors said they believe that factors can be effectively applied to fixed income with only 10% viewing it as impossible to implement smart beta fixed income funds. The fund manager conducted over 300 interviews with global institutional investors, fund managers, and others.
Houweling says they are seeing pension, sovereign wealth funds and some wholesale providers and insurers starting to embrace this approach. Out in front are Scandinavia, the Netherlands, the UK and Germany who are quant-oriented, along with Australia, the Middle East and Singapore.
“In the US they are aware of the factor equity story, but in fixed income it is still relatively early days,” he adds. “In the future, we expect that five to ten years from now, the market for factor investing in credits will have further matured and that more investors will have adopted factors in their investment portfolios – either as a strategic allocation, next to passive and traditional active credit implementations, or as a style diversifier in a pool of multiple active managers”.