So far, the performance of mainstream fixed-income factor funds hasn’t been electrifying, while the relentless risk rally makes vanilla carry strategies a winning style. But the promise is powerful.
Quants have long believed you can take advantage of behavioral biases by sorting shares according to their characteristics, called factors. Investors overlook boring stocks, for example, so buying companies posting muted volatility will allow you to outperform. There’s big money at stake. Beyond mutual and hedge funds, the factor theory also underpins smart-beta passive products with about $1 trillion in assets, around 97% of which is in stocks.
In credit, systematic traders sort corporate obligations into buckets called carry, value, momentum and size to analyze spreads relative to credit risk, leverage, the size of the issuer and ease of trading.
Factor devotees say their volatility-adjusted approach sidesteps yield-chasing antics and duration risk. And after back-testing, JPMorgan Chase & Co. estimates long-only factors can best the market over the long haul.
“These strategies are basically a hedge to the overweight cyclical carry strategy that many long-only credit funds use,” said Saul Doctor, a credit strategist at JPMorgan, which is among Wall Street firms proselytizing the newfangled trade in recent papers. “In the next back-up in spreads, their funds should outperform.”
The pitch looks timely. The supercycle is a decade old, and any reversal could hurt traditional investors who’ve largely outperformed by chasing yield.
According to AQR, traditional bond funds have generated alpha in the past two decades simply by virtue of taking bigger risks in speculative-grade companies that pay higher yields, or by putting money on the line for longer and longer.
Spinning bonds into algorithmic gold not only requires human talent, but a robust collection of prices and computing power. Unlike equity, where a company has one stock, there are countless bonds per firm where prices aren’t reported on transparent exchanges. Then you have to trade the things, which requires relationships with brokers, access to the right platforms and flexibility to navigate liquidity issues.
Breeze in a Hurricane
Working with data it first sourced from Lehman going back to the late 1980s, Netherlands-based Robeco built up a library of credit resources to construct automated strategies. For some skeptics, it’s barely enough.