Smart-beta and factor-based investing have swept the equity landscape, with investors big and small talking about ways to approach their portfolios from a factor perspective. What about bonds?
IndexIQ Chief Investment Officer Sal Bruno will tackle this topic at the forthcoming Inside Smart Beta conference, taking place June 8-9 in New York City. Inside ETFs CEO Matt Hougan sat down with Bruno recently to figure out how and if smart beta can work in a fixed-income framework.
Matthew Hougan, CEO, Inside ETFs: Smart beta has historically been an equity-focused phenomenon. What are the factors that drive performance in the fixed-income space, and why do they drive performance?
Sal Bruno, IndexIQ Chief Investment Officer: There are some great parallels with bringing factors from the equity world into the fixed-income world. Take something like momentum. Momentum has worked for 25 to 30 years in equities, and is well-documented, but it turns out it’s also worked in currencies, commodities and fixed income.
There are some challenges in fixed income that you need to accommodate. For instance, individual bonds are expensive to trade, so liquidity becomes a more important issue than it is in equities. So maybe you don’t apply momentum to individual bonds, but you instead look at sectors, which you can proxy with more liquid instruments like ETFs.
The same thing is true when you think about a factor like low volatility. High-yield bonds tend to be similar in a lot of way to equities. People tend to overweight some of the highest-risk names … leaving some of the lower-volatility names undervalued.
Again, there are some challenges: [You have to figure out how to] evaluate volatility in individual bonds. But once you do, you can think about it in very much the same way you do in the equity world.
Hougan: When you say there are challenges in evaluating the volatility of individual bonds, what do you mean?
Bruno: For equities, you can just use the percentage change on a daily basis and take the standard deviation, and that’s your volatility. But because bonds don’t trade every day, you can have gaps in those sequences. Also, you have some nonstationary characteristics in bonds such as the maturity and duration are changing through time for the same bond.
[That makes it] a little bit more difficult. The volatility profile of that individual bond is changing through time, so you need to think a little bit more carefully. Maybe you look at some other market-implied metrics to calculate what constitutes volatility for bonds at the individual level.
Hougan: But once you do, you see the same pattern of outperformance for lower-volatility securities in bonds as you do in equities?
Bruno: You do. People bid up high beta in the equity world and higher-yielding bonds in the high-yield space. They overpay for those … and that leaves some better values to be had in the lower-volatility names.
Hougan: Who’s chasing those higher-volatility bonds?
Bruno: Investors looking for higher yields. We saw that coming out of 2016 in February when credit spreads had blown out to 800-850 basis points over the comparable Treasury. Folks started chasing those yields, and you ended up with a spread over Treasuries of somewhere around 300-320 basis points, close to the all-time lows.
Those who rode the curve did well, but when that situation started to reverse itself and spreads widened out again, the higher-vol names suffered, and those employing a low-volatility approach benefited.
Hougan: Have these ideas been present in the hedge fund universe or the active bond universe, or is this a new academic insight?
Bruno: There was a paper in 2013 that came out and talked about “Value and Momentum Everywhere” that touched on using momentum in fixed income, and another paper that came out in 2015 that looked at using momentum in the Treasury market.
Our unique insight was how we constructed the momentum signal, how we put it together in a disciplined, rules-based process, and then how we used other ETFs to get exposure and overcome the liquidity barrier.
Hougan: At the tail end of a 35-year bull market, what should investors do with the bond portion of their portfolio? Should they continue to hold bonds?
Bruno: We think it’s important to continue to hold bonds in a portfolio … but how you get that exposure could be very important. Our fixed-income momentum ETFs—the IQ Enhanced Core Bond U.S. ETF (AGGE) and the IQ Enhanced Core Plus Bond U.S. ETF (AGGP)—are meant to be replacements for the core aggregate position of a portfolio.
They aren’t unconstrained bond funds, so we have risk-control limits and tracking error targets, and the same thing is true on our high-yield ETF, the IQ S&P High Yield Low Volatility Bond ETF (HYLV). We’re trying to create a way for investors to maintain core exposure to the market while lowering the volatility of their overall portfolio.
Hougan: One thing that’s true of any smart-beta strategy is that it won’t beat the market every day. In what kind of markets will these strategies underperform, and what should investors do about that?
Bruno: That depends on what sort of factor you’re looking at.
Clearly, in momentum-based strategies, when you’re in choppy markets, those will have a hard time, because you’re trying to pick up on a strong trend. One of the things we’ve tried to do is take a disciplined, rules-based approach to targeted tracking error. That way, even if the market isn’t working for you, you’re not taking exorbitant risks.
In something like low volatility, if you’re in a risk-on trade, a lower-vol offering will probably underperform. If credit spreads go from 8% to 3%, for instance, that’s an environment where low vol will underperform.
But when you get that reverse move and you move back from 3% to 6% or 8%, you’d expect lower vol to outperform. Because there are asymmetries in the returns—if something goes down a certain amount, it has to go up a lot more to get back to breakeven—that’s where we think using some of these products over the full cycle can really be beneficial.
Hougan: Any last thoughts?
Bruno: We’re looking at an environment where rates are more likely to rise than they are to fall, and spreads are more likely to widen than they are to come back down. We think it’s a really interesting and opportune time … for advisors to take a look at these strategies and think about how they might want to use them in a portfolio.