Case study: US bond managers perform better with factors
While the previous example represented a theoretical problem, we use actual investment manager data here to show how quality and value factors can improve the risk-adjusted performance of carry portfolios.
We construct quality and value-tilted core bond funds which each own securitized and US Treasury allocations with similar weights to the Bloomberg Barclays US Aggregate Index. Credit factors are added at weights similar to credit in the aggregate index – one with most of the allocation to quality and the other with most of the allocation to value. We then create a new portfolio by combining 90% of an existing active manager portfolio with a 10% allocation to one of the factor portfolios. Figure 7 shows that the majority of existing managers’ information ratios are improved with an allocation to one of the two factors, even at the low 10% weight. The result is consistent with figure 5 – i.e. the risk-adjusted returns of carry-based portfolios can be improved with a diverse factor allocation.
By analyzing the addition of factors to four common use cases in fixed income investing, including: (1) using factors to improve on a portfolio diversified across rating, maturity and industries, (2) adding factor exposure to a multi-sector credit allocation, (3) utilizing factors in a balanced stock and bond portfolio and (4) completing or risk-controlling an existing active approach, we show that managed factor exposure can potentially improve results across risk and return objectives. Both academic and practitioner research has shown that investors have a meaningful amount of factor exposure, whether they employ a factor investing strategy or not.4 We believe a natural conclusion is for investors to adopt a more explicit approach to the monitoring and managing of their fixed income factor exposures.
This article was first published in Risk & Reward - Q2 2019. Jay Raol, PhD, is Director of Quantitative Research for Invesco Fixed Income.
^1 Raol, J. and Pope, S. (2018), “Why should investors consider credit factors in fixed income?”, AIAR Vol. 7(3)
^2 For example: Frazzini, Andrea and Pedersen (2014), “Betting Against Beta”, Journal of Financial Economics, 111, 1-25. Low volatility bonds are typically characterized as bonds with short maturities and low default risk.
^3 Raol, J. and Quance, S. (2019), “Active bond funds – powered by factors”, Risk & Reward #1/2019, pp. 4-8.
^4 See also footnote 2 and Ang, Goetzman and Schaefer (2009), “Evaluation of Active Management of the Norwegian Government Pension Fund – Global”.