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.
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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.”
Latest Research
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.”
Read the full article here by Larry Swedroe, Advisor Perspectives
