Could it catch up with Equity markets?
By Hamlin Lovell, NordicInvestor
“Smart beta”/factor investing/risk premia/style premia is thus far much more widely adopted in equity markets, than in fixed income or credit markets. This is changing however, with more academic research and product launches in the space. The 2018 FTSE Russell Smart Beta Survey found 27% of respondents had already allocated to smart beta credit strategies – or were contemplating doing so (based on surveying 185 asset owners from North America, Europe and Asia Pacific, running over $3.5 trillion).
In Scandinavia, the Nordic survey on factor investing in credits produced by Casper Hammerich, CAIA, Principal of Kirstein A/S; Jeroen van Zundert, PhD, CFA Quantitative Researcher at Robeco and Patrick Houweling, PhD Head of Quantitative Credits, Robeco carried out interviews with 31 institutional investors in the four main Nordic countries, who run EUR 435 billion – roughly one third of institutional assets in the Nordics -, and are mainly pension funds or insurance companies. This survey also identified a sharply increased interest in credit risk premiums.
The level of interest varies by country. Given the strong local bond investing culture, it is predictably Danish allocators who are most keen, followed by Finns, Swedes and Norwegians (Iceland, Greenland and the Faroe Islands were not surveyed). Firms with larger teams were also more interested.
The survey also found that more experienced investors are most likely to be have a preference for running fixed income risk premium strategies in house (which is one reason why smart beta credit has a lower public profile), though many will use asset managers, hedge funds or investment banks; those less experienced with risk premiums are most keen to use asset managers.
Smart beta credit products
The growing menu of smart beta credit products will be useful for those who allocate externally – and indeed those who want to negotiate bespoke strategies through separately managed accounts. We touch on a handful of examples.
Overall, switching from a 25% passive credit allocation to these credit factors, would have increased returns by around 1% a year, without raising risk
Robeco has been managing credit factor strategies internally since 2005, and externally since 2012. They have produced alpha close to the back-test set out in Robeco’s academic paper ‘Factor investing in the corporate bond market’, which shows how systematically allocating to four factors (size, value, momentum and low risk), would have generated better risk-adjusted returns than a market-value weighted index. Each factor has outperformed by itself. Taken together, the four have generated even better risk-adjusted returns, as they are lowly correlated. Overall, switching from a 25% passive credit allocation to these credit factors, would have increased returns by around 1% a year, without raising risk, between 1994 and 2017.
It is also true that a high proportion of more traditional, discretionary, fundamental credit managers have beaten their benchmarks (the case for passive investing seems weaker for fixed income and credit than for equities). Credit factor investing is a potentially complementary – and powerful – diversifier to traditional active credit management. The outperformance obtained from Robeco’s credit factor return profile is in fact negatively correlated to any of 25 active credit funds reviewed.
It is also a useful diversifier for equity exposure. In a wider portfolio context, the credit factors may sound similar to equity factors, and seem conceptually similar – but they show low correlations to equity factors.
Robeco believe that the factors should continue to work, because they are grounded in behavioural finance, which in turn is driven by human biases
State Street Global Advisers (SSGA)’s Fixed Income Smart Beta strategy takes a somewhat different approach, decomposing bond returns into risk premia, including term factor premia, liquidity factor premia, and credit factor premia. SSGA build multi-factor portfolios of sovereign and corporate debt that are based on quality, volatility and value rankings, rather than on market capitalisation weights. SSGA cite academic research on value, momentum, liquidity risk, and low risk anomalies, as a foundation for their approach.
In the European credit market, Ossiam (which is part of the Natixis family) has launched a smart beta investment grade credit ETF: Ossiam Solactive Moody’s Analytics IG EUR Select Credit ETF, which selects a basket of bonds from the Solactive Euro IG Corporate Index. The selection is based on three criteria: liquidity, default risk, and valuation, using analytics from Moodys and Solactive. The strategy does not take off-benchmark bets on duration or sector exposures. The total expense ratio is 0.35%.
In the Canadian credit market, the WisdomTree Yield Enhanced Canada Aggregate Bond Index ETF [ticker “CAGG”] and the WisdomTree Yield Enhanced Canada Short-Term Aggregate Bond Index ETF [ticker “CAGS”]. The first aims to track the Bloomberg Barclays Canadian Aggregate Enhanced Yield Index, which selects bonds from the Bloomberg Barclays Canadian Aggregate Index. The second aims to track the Barclays Canadian Short Aggregate Enhanced Yield Index, which selects bonds from the 1-5 year segment of the same index. Management fees are 0.18%.
Applying factor investing to fixed income and credit markets does indeed involve some unique issues that do not apply to large cap equities
In the US market, BlackRock takes a markedly different approach. Whereas most of the strategies above are based on bottom-up security selection, BlackRock is taking a more top-down approach based on big picture risk aggregation. Sara Shores, Head of Strategy for BlackRock’s Factor-Based investments, argues that smart beta approaches to credit should prioritise two macro-economic risks: interest rate and credit risk, as these are the key return drivers for credit, and they have more impact than security-specific risk. BlackRock’s first fixed income smart beta ETF, iShares US Fixed Income Balanced Risk [ticker: INC] aims to make dynamic shifts balancing out these two factors in the US market. The total expense ratio is 0.26%.
ESG and Smart Beta
AXA IM’s Lise Moret, Head of ESG Quantitative Solutions, argues that ESG factors can be combined with Smart Beta Factors, to create an ESG Smart Beta credit portfolio, with higher returns and improved diversification versus conventional credit indices.
Complications and nuances
However, some allocators are not yet convinced on the case for smart beta credit. Concerns identified by Kirstein include crowding in conventional risk premiums, sourcing capable managers and lack of liquidity. Applying factor investing to fixed income and credit markets does indeed involve some unique issues that do not apply to large cap equities.
Robeco accept that the heterogeneity of the corporate bond universe (with some companies issuing hundreds of different bonds) poses a challenge for implementation, as specific bond issues with appropriate risk and value qualities would need to be identified. Robeco acknowledge that corporate bonds have lower liquidity and higher transaction costs than equities, but believe that these constraints can be fed into the optimisation process.
Liquidity cannot be ignored however. Robeco accept that it is harder to pursue credit factor strategies on a long/short basis, as a limited subset of bonds can be shorted (via either cash bonds or CDS).
Robeco also realise that their factors do not measure fundamental considerations such as management quality, country risk or new legislation, and therefore feel that a discretionary overlay is needed to filter out some bonds. So, theirs is not a 100% systematic or quantitative strategy running on auto-pilot, but rather a predominantly systematic one with some human intervention.
Investors should watch this space as a greater variety of smart beta credit strategies are launched over the coming months and years. The segment is already rather different from smart beta equity strategies – and may further decouple.
Alternative Risk Premia (ARP)
Over 50 ARP strategies have been launched, and some of them are investing in various fixed income and credit risk premia, alongside five or ten other risk premia strategies. ARP will generally be long/short strategies and smart beta will generally be long only.