Factor-Based Investing Beats Active Management for Bonds
Factor-driven investing, while highly popular among equity investors, has not been as widely adopted in the bond market. But research shows that a factor-based approach to bond investing is superior to attempting to identify top-performing active bond managers.
Professors Eugene Fama and Ken French are best known for their 1992 study, The Cross-Section of Expected Stock Returns, which led to the development of the three-factor equity model (market beta, size and value), the four-factor equity model (adding momentum) and the six-factor model (adding profitability and investment). Less known is that, in their 1993 paper, Common Risk Factors in the Returns on Stocks and Bonds, Fama and French also proposed a two-factor (term and default) model to explain bond returns.
Recently, other factors have been proposed as adding explanatory power to bond returns. For example, in their 2018 study, Style Investing in Fixed Income, published in The Journal of Portfolio Management, Jordan Brooks, Diogo Palhares and Scott Richardson of AQR Capital Management identified four fixed-income style premiums:
- Value: the tendency for relatively cheap assets to outperform relatively expensive assets;
- Momentum: the tendency for an asset’s recent performance to continue in the near future;
- Carry: the tendency for higher-yielding assets to outperform lower-yielding assets; and
- Defensive (quality): the tendency of safer, lower-risk assets to deliver higher risk-adjusted returns than their low-quality, higher-risk counterparts.
They found that applying the four style premiums identified in other asset classes would have enhanced returns in various fixed-income markets over the past two decades. They concluded: “Our empirical analysis suggests a powerful role for style-based investing in fixed income.”
Stephen Laipply, Ananth Madhavan, Aleksander Sobczyk and Matthew Tucker contribute to the literature on factor investing in bonds with their study, Sources of Excess Return and Implications for Active Fixed-Income Portfolio Construction, which appeared in the quantitative special 2020 issue of The Journal of Portfolio Management. They used the new factor tools to gain a better understanding of fund manager performance and optimal portfolio construction techniques. They began by noting: “Proponents of active management cite a variety of issues unique to fixed income – including the proliferation of securities, skewed risk-return profiles, the significance of new issues, and the illiquid, opaque nature of the bond market – that could pose considerable challenges for indexing. Consequently, critics argue, fixed-income index strategies underperform active strategies on average and can even fall short of their own benchmarks. These claims have been persuasive to investors. Indeed, of the $3.3 trillion assets in US fixed-income mutual funds, 82% ($2.7 trillion) are invested in active funds.”
The authors used holdings-based factor attribution analysis (as opposed to regression analysis) to examine the performance of a comprehensive dataset of 221 U.S. active investment-grade and high-yield mutual funds with more than $525 billion in assets in the period December 31, 2015, to June 30, 2018. They noted: “Factor attribution marries the fund holdings with a multifactor model to better understand the sources of alpha.” Their goal was to determine how much of a fund’s performance relative to its benchmark was attributed to (1) returns to static factor exposures, such as a constant tilt to credit risk; (2) factor timing, where the manager varies the exposure to factors such as duration over time, and (3) individual bond security selection, which is the fund’s return in excess of static and time-varying factor exposures. To determine factor exposure, they used the BlackRock Fixed-Income Risk Model (BFIRM), a fundamental factor-based risk model that is part of the Aladdin product offering used by many large institutions to construct portfolios and monitor risk. Following is a summary of their findings:
- In the aggregate, active bond managers outperformed their stated benchmarks, consistent with an argument for active management of bond portfolios.
- Asset-weighted returns for active investment-grade bond funds outperformed the prospectus benchmark index by 0.91%. However, almost all of that was explained by static exposure to common factors. For example, manager skill contributed 0.47%, exceeding expenses of 0.39% by just 0.08 percentage point per annum.
- Asset-weighted returns for active high-yield funds was poor, underperforming the prospectus benchmark by 1.49 percentage points. Expenses explained just 0.60% of the underperformance. The high-yield factor contributed -0.49%. Manager skill made virtually no contribution (0.04%), and there was no evidence of a consistent level of skill across alpha sources.
- There was no evidence of duration as a significantly consistent contributor to fund performance.
The authors noted that while active managers often claim bond markets are less efficient than equity markets in various dimensions (including having lower and discontinuous liquidity, less price transparency and fragmented trading markets, and therefore a greater number of mispriced securities and sectors that offer opportunities for alpha generation), they found evidence of security selection skill only with top-performing managers, not across the industrywide population of active funds examined. Furthermore, they found that the return contribution of security-selection alpha is smaller than that of factor tilts across managers of all skill levels. In other words, investors could basically replicate the performance of active managers through simple combinations of low-cost government, investment-grade credit and high-yield credit exchange-traded funds, or ETFs (bond ETFs can cost less to trade than individual securities), which can provide a continuum of exposure to credit risk and a range of duration exposures.
These findings are entirely consistent with prior literature, including the study, Give Credit Where Credit Is Due: What Explains Corporate Bond Returns? by Roni Israelov. Israelov found that systematic exposures compensate bond investors via the bond, equity, equity volatility and bond volatility risk premia. However, idiosyncratic exposures (obtained via individual security selection) provide risk without reward, on average.
These findings are also consistent with those of Peter Mladina and Steven Germani, authors of the study, Bond-Market Risk Factors and Manager Performance, which appeared in the September 2019 issue of The Journal of Portfolio Management. For example, they found that the U.S. investment-grade bond market is almost perfectly explained by the three common risk factors of term, default and prepayment (many corporate bonds and municipal bonds have call provisions, as do mortgage-backed securities). Interestingly, they also found that “the default factor is redundant with the market factor of equities – it is merely a linear combination of the Fama-French market factor. The default factor has a 0.34 market beta that is highly statistically significant (t = 13.64), whereas its -0.45% alpha is insignificant (t = -0.34). In other words, the compensated returns of the default factor are replicated by holding 34% equities and the rest in T-bills.” This finding led them to conclude that because the default factor is well explained by the exposure to market beta, along with the very small default premium, it calls into question the prudence of investing in publicly traded high-yield bonds – especially after considering the higher costs of actively managed high-yield bond funds.
We’ll review the results of one more paper, the 2009 study, Is There Skill among Bond Managers? by Marlena Lee, co-head of research at Dimensional Fund Advisors. Lee employed modified Fama-French term and default factors in combination with market, size and value factors to risk adjust alphas. Her sample included 2,353 active U.S. investment-grade, high-yield and government bond funds and covered the period January 1991 to December 2008. Following is a summary of her findings:
- In aggregate, active bond funds underperform appropriate benchmarks by an amount roughly equal to fees.
- All categories of funds (government, corporate, high yield) produce negative net alphas.
- There is no evidence of winner persistence in net returns beyond the randomly expected. We cannot separate skill from luck.
- Collectively, investors in active bond funds lose about 90 basis points per year, or about $1.4 billion in 2008, in underperformance – a triumph of hope over experience.
The reported results we covered have important implications for investors in terms of portfolio construction, risk monitoring and manager selection. Because the term, default and prepayment factors explain almost all the returns of bond portfolios, investors should construct their bond portfolios with these factors in mind and then carefully monitor their exposure to these systematic risks.
Because the findings show little evidence of persistent ability to generate alpha beyond the randomly expected, investors should choose their fixed-income managers based mainly on expense ratios and exposure to term risk (the default premium was not only well explained by market beta, but it has also been very small, even before costs).
Lastly, because factor betas drive compensated return and risk in bonds, it is far more important to capture desired factor betas efficiently than to seek alpha.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.