The Factor-Based Approach to Fixed Income

Combining low volatility and value factors can produce better risk-adjusted returns when applied to fixed income strategies, according to research by S&P Dow Jones Indices (S&P DJI).

The combined factors outperformed both broad US fixed income benchmarks and a sample of actively managed funds in tests run by Aye Soe and Hong Xie, directors in S&P DJI’s global research and design team.

“Our analysis indeed confirms that over the backtested investment horizon, both value and low-volatility factor portfolios have higher Sharpe ratios than the broad market,” Soe and Xie wrote. “When evaluated in a two-factor framework, the two-factor portfolio exhibits similar risk-efficient characteristics, even after accounting for hypothetical transaction costs.”

The “majority” of risk in active fixed income portfolios was down to systematic factors, the authors argued. They found that volatility-aware strategies could act as a “risk control mechanism,” similar to the factor’s role in equity products.

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The “two-factor portfolio” Soe and Xie constructed had a higher Sharpe ratio than the average active US fixed income fund when rebalanced either quarterly or monthly, when backtested from July 2006 to August 2015. The monthly rebalanced strategy had a higher information ratio than the average active fund, implying that it would produce more alpha per unit of risk.

Soe and Xie cited recent research by Ronald Kahn and Michael Lemmon—managing directors within BlackRock’s “scientifically driven active equity” group—which found that investors may be overpaying for their exposure to this asset class due to the prevalence of factors driving active fixed income returns.

“Backtested results show that a multi-factor index could maintain a target risk profile (ratings and duration) in line with the broad-based benchmark, while having the potential to provide higher risk-adjusted return,” Soe and Xie wrote.

However, portfolio turnover remains a problem to be addressed in factor-driven strategies, the authors added. The monthly rebalanced two-factor strategy had a turnover rate in excess of 400%, pushing up expected costs. The quarterly rebalanced portfolio had a turnover rate of 239%, which Soe and Xie said was “comparable to that of actively managed bond funds.”

Read the report in full: “Factor-Based Investing in Fixed Income: A Case Study of the US Investment-Grade Corporate Bond Market.”

The state AFL-CIO chapter presented a plan to drop its alternatives investments and revert to a “responsible, traditional allocation of stocks and bonds.”

New Jersey’s labor unions have demanded the state pension fund eliminate alternative investments in favor of a traditional 60/40 model.

The proposal called for the New Jersey State Investment Council to replace hedge funds with a combination of stocks and bonds over the next three months. The New Jersey State American Federation of Labor & Congress of Industrial Organizations (AFL-CIO), along with Focus Investment Bank Managing Director Jeff Hooke, also recommended private equity commitments be “run off” over time to make room for public equities.

These suggestions follow public scrutiny of the fees the $79 billion pension fund has paid to alternatives managers, which totaled more than $600 million from 2012 to 2014.

“The performance of the alternative investments does not justify their outrageous cost,” said New Jersey State AFL-CIO President Charles Wowkanech in a statement. “Let’s stop making Wall Street millionaires into Wall Street billionaires and return to a responsible, traditional allocation of stocks and bonds.”

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In a written response to the AFL-CIO plan, investment chief Christopher McDonough criticized Hooke’s analysis for containing “numerous inaccurate returns,” “vague references,” and “unclear calculations.”

“The analysis is entirely backward-looking and focused over a relatively short period of time,” McDonough wrote. “There is no acknowledgement or consideration of current market conditions.”

Furthermore, McDonough said a “significant amount of data mining and cherry picking” was used to support the proposal, including a number of “obscure” indexes used for performance comparison. Much of the analysis was based on comparing investment strategies to S&P 500 returns, which “have benefited from unprecedented central bank intervention over the recent period, support which is unlikely to continue going forward,” he added.

“With the benefit of hindsight it is always possible to find a portfolio that would have done better than the one you were invested in,” he wrote. “Comparing almost any other investment option to the S&P over the past five years is going to result [in] underperformance for that asset class.”

The investment division began diversifying away from strictly long-only stocks and bonds 10 years ago, McDonough said, after “excessive reliance” on public equities resulted in a loss of $17 billion from 2001-2002, 25% of the fund’s assets at the time.

An Aon Hewitt analysis of New Jersey’s current diversified portfolio, presented at the fund’s January investment meeting, found that it outperformed a 70/30 allocation for all rolling 10-year periods from 2003 to 2015.

“Unlike Mr. Hooke, the Division of Investment is a fiduciary to the plan participants and invests the portfolio solely in their best interest,” McDonough said.