Your fixed income portfolio may have more factor exposure than you realized

The factor lens can increase transparency, help explain portfolio movements and clarify an active manager’s skill.

Apr 15, 2019 | Jay Raol, Stephen Quance, Shane Gallagher

Risk & Reward spoke to Invesco’s Jay Raol and Stephen Quance, authors of the bond factor study (article) in this issue, as well as senior associate client portfolio manager Shane Gallagher, about factor investing in the fixed income domain.

Risk & Reward
Why do you think it is important to look at fixed income portfolios through a factor lens?

Stephen Quance
We see factor investing as a global trend that marks a permanent shift in how assets are managed. One reason is that analyzing factor exposure in a portfolio is informative and useful. This applies to fixed income markets just as it does to equities. In our article, we looked at a broad range of US core fixed income portfolios and found that, whether explicitly targeted or not, factor exposures drove much of their performance. Indeed, factors may have been behind much of the average fixed income manager’s outperformance over the last ten years. In other words, investors are factor investors whether they know it or not. Looking at portfolios through a factor lens can help increase transparency, identify existing risk exposures and clarify manager performance.

Risk & Reward
What are fixed income factors?

Jay Raol
Investment factors are directly observable characteristics of securities. They can be used as part of live strategies to help investors achieve particular outcomes. We believe that every factor must be backed by a reasonable theoretical rationale and confirmed by empirical analysis. For example, he value factor can identify bonds priced lower than heir peers. All else held constant, lower prices imply higher returns – this holds true for bonds as well as other assets. But we have identified additional fixed income factors: the carry factor explains risk-adjusted excess returns from holding higher yielding bonds. The liquidity factor explains risk-adjusted excess returns from holding less-liquid bonds – often older vintage, with smaller issue sizes. The quality factor explains risk-adjusted excess returns from holding low-volatility bonds, which are typically of short maturity and have higher ratings. Each factor helps explain the risk and return associated with holding different types of bonds.

Risk & Reward
How do typical fixed income portfolios stack up in terms of factor exposure?

Jay Raol
We found that the median fixed income manager in the Morningstar universe was exposed to multiple factors. For each fund in the universe, we regressed factor returns against active returns, taking into account our value, carry, liquidity and quality factors. We observed that the median manager had materially positive exposure to carry, liquidity and value. 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. To a lesser extent, managers held securities that were cheap relative to their sector and rating peers. On average, we found that factor exposures explained 66% of bond managers’ excess returns.

Risk & Reward
What do these findings mean for fixed income investors?

Stephen Quance
Investment decisions require more and moretransparency and information. At Invesco, we classify investment approaches into three categories, or “pillars”: fundamental high conviction security selection (aka, alpha-seeking), market weighted and factor investing. There are advantages and disadvantages to each, so understanding what you have is useful. For example, an investment fee ought to reflect the value provided to the client as well as the cost associated with providing that value. Therefore, we believe funds with consistent factor exposure, but little alpha, should cost less than a high-alpha fund. But they should cost more than strategies that only replicate a market index. However, our research finds no clear relationship between factor exposures, alpha and fees. Understanding an existing portfolio’s factor tilts helps us understand whether it makes sense to replace part of the portfolio with a new strategy or whether a new strategy can complement existing ones.

Risk & Reward
What do your findings suggest as to how fixed income investors could approach their portfolios?

Shane Gallagher
We encourage investors to consider the current factor exposures of their portfolios and, where appropriate, adjust them to better align their risk profile with return objectives. Alpha can be a key component of investment returns, as evidenced by the 34% of returns not explained by factor exposure. The same is true for low-cost strategies that replicate an index. However, a factor framework can add value by identifying some of the risks in a portfolio and providing a way to adjust them, if warranted. Not only could the factor lens result in outcomes more suited to an investor’s objectives, it can also increase transparency, help explain portfolio movements and clarify an active manager’s skill in an efficient, scalable and cost-effective way.

Risk & Reward
How can factors be employed in portfolios? What are the benefits of single- versus multi-factor strategies?

Jay Raol
The answer depends on what investors are trying to achieve and what constraints must be respected. Since such a large part of excess return is explained by factors, it seems only natural that factor strategies could play a central role in a portfolio. A single-factor solution can be used to complete a portfolio that might be lacking exposure to a desired factor. For example, additional exposure to the quality factor could balance the natural carry and value tilts of the median active manager. However, single factors can go through long periods of outperformance and underperformance relative to the benchmark. Therefore, 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.

Risk & Reward
Thank you very much for your time.

Related articles:

Factor investing at Invesco

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