Combining low volatility and value factors can produce better risk-adjusted returns when applied to fixed income strategies, according to research by S&P Dow Jones Indices (S&P DJI).
The combined factors outperformed both broad US fixed income benchmarks and a sample of actively managed funds in tests run by Aye Soe and Hong Xie, directors in S&P DJI’s global research and design team.
“Our analysis indeed confirms that over the backtested investment horizon, both value and low-volatility factor portfolios have higher Sharpe ratios than the broad market,” Soe and Xie wrote. “When evaluated in a two-factor framework, the two-factor portfolio exhibits similar risk-efficient characteristics, even after accounting for hypothetical transaction costs.”
The “majority” of risk in active fixed income portfolios was down to systematic factors, the authors argued. They found that volatility-aware strategies could act as a “risk control mechanism,” similar to the factor’s role in equity products.
The “two-factor portfolio” Soe and Xie constructed had a higher Sharpe ratio than the average active US fixed income fund when rebalanced either quarterly or monthly, when backtested from July 2006 to August 2015. The monthly rebalanced strategy had a higher information ratio than the average active fund, implying that it would produce more alpha per unit of risk.
Soe and Xie cited recent research by Ronald Kahn and Michael Lemmon—managing directors within BlackRock’s “scientifically driven active equity” group—which found that investors may be overpaying for their exposure to this asset class due to the prevalence of factors driving active fixed income returns.
“Backtested results show that a multi-factor index could maintain a target risk profile (ratings and duration) in line with the broad-based benchmark, while having the potential to provide higher risk-adjusted return,” Soe and Xie wrote.
However, portfolio turnover remains a problem to be addressed in factor-driven strategies, the authors added. The monthly rebalanced two-factor strategy had a turnover rate in excess of 400%, pushing up expected costs. The quarterly rebalanced portfolio had a turnover rate of 239%, which Soe and Xie said was “comparable to that of actively managed bond funds.”
Read the report in full: “Factor-Based Investing in Fixed Income: A Case Study of the US Investment-Grade Corporate Bond Market.”