Are factors the X-factor behind active bonds' performance?

New quantitative research suggests that portfolio managers’ skill do little to explain their funds’ long-term excess returns

Are factors the X-factor behind active bonds' performance?

Active managers have been presented as a more sophisticated alternative to passive, index-based funds. But those working in the bond space may not have as much of an edge as they think.

“According to new quantitative research from Invesco, the majority of excess returns generated by a large sample of U.S. bond funds can be explained by their exposure to factors, not the specific skill of the portfolio manager,” reported Institutional Investor.

Factor-based funds — those designed to capture value, momentum, and other characteristics of securities that can explain long-term excess returns — have gained increasing attention in equity markets. But they are still finding their footing in the bond fund world, were there isn’t as much academic research to support the effectiveness of factors.

“You have a situation where a lot of active managers in equities are struggling, but bond managers have been able to beat their benchmarks,” said Jay Raol, Jay Raol, director of quantitative research in Invesco’s fixed-income unit and co-author of the study, in an interview with Institutional Investor.

Morningstar data shows that in the 12 months through June last year, just 36% of active US equity funds outdid their benchmarks. In contrast, over 70% of intermediate-term bond funds did better than their corresponding passive indexes.

In its study titled Active Bond Returns – Powered by Factors, Invesco analysed data on 65 of the largest asset managers who count among the “core plus” category of funds classified by Lipper from January 1, 2007 to June 30, 2018. The researchers looked at returns from value, carry, liquidity, and quality for each fund in the group. The value factor looks at bonds priced lower than peers; carry characterizes higher-yielding bonds; liquidity explains risk-adjusted excess returns from holding less liquid bonds; and quality accounts for the return benefits of holding low-volatility bonds.

Invesco’s researchers found that factor exposures explained an average of 66% of the excess returns reported by bond managers. According to Raol, the 70% outperformance rate seen among intermediate-term bond funds wasn’t built on unique investment insights; instead, it came from the funds’ exposure to value, carry, liquidity and quality factors. The majority of funds’ factor exposure, Invesco found, came because they held older, smaller-issue size bonds with lower ratings and longer maturities.

The report also highlighted how ratings downgrades contribute to the value factor exposure of a bond fund. Bonds tend to shed value right before a credit ratings agency announces a downgrade. But after that, they also tend to recover, depending on the overarching economic backdrop.

“This risk-return tradeoff is the basis of factor investing,” Raol said.


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