Think at London Business School
Thursday 24 November 2022
As Britain heads into a long winter of discontent, with households squeezed and recession looming, what can business expect?
By Andrew Scott, Seb Murray
Fixed-income securities, such as government debt and corporate bonds, comprise a huge market, but for investors, with government bond yields at very low levels for the last few years and heightened risk of rising interest rates amid inflation uncertainty, generating attractive risk-adjusted returns in fixed income markets is challenging.
Coupled with a pervasive reaching for yield tendency of active fixed income managers, there is demand for true diversifying alpha with fixed income markets. A well-implemented systematic investment approach for fixed income offers the potential for attractive diversifying returns for asset owners. Professor Scott Richardson’s new book Systematic Fixed Income: An Investor’s guide provides an exhaustive overview of what it takes to be a successful systematic fixed income investor.
Fixed-income securities totalled just over US$123 trillion in December 2020, according to the Bank for International Settlements. Once money-market instruments and bank loans are added to the pot, the figure could be closer to US$200 trillion. By way of comparison, global equity markets were valued at $106 trillion at the end of 2020.
For investors, there are very many fixed-income securities from which to choose – perhaps too many. Across both government and corporate bond issues, liquidity is spread across what seems an excessive number of securities, and liquidity problems are exacerbated by a lack of standardisation in the market for corporate debt.
Alongside this there has been a clear downward trend in bond yields, the last few months aside, over the past several decades. This is a global trend, and yields remain at relatively low levels. In such a landscape, achieving excess returns is challenging. A systematic approach can offer the potential of attractive excess returns.
A ‘systematic’ investment approach is to be contrasted with a traditional discretionary approach. What distinguishes these two investment philosophies?
Arguably, all investors in fixed income markets are quantitatively oriented. After all, everyone in fixed income markets is conversant with yields, durations, convexities and other measures, all of which require a sound understanding of calculus. So, quantitative awareness is insufficient to distinguish a systematic investor.
A common understanding of the drivers of risks and returns of fixed income securities is also likely to be similar across discretionary and systematic investors. Views on inflation and growth are the important ingredients for successful investing in government bonds, for both discretionary and systematic investors. Likewise views on leverage, volatility and free cash flow generating capability are the key for successful investing in corporate bonds, for both discretionary and systematic investors.
While the investment narrative is similar for discretionary and systematic investors, how they translate their investment narrative to portfolio weights is really what distinguishes the systematic investor. Discretionary investing involves a “best ideas” approach, a reliance on individual managers and concentrated portfolios. Systematic investing involves a model-based approach, a reliance on a systematic process and diversified portfolios.
A major difference is the role of human intervention in the process. In systematic investment, the “human factor” is most important at the start of the process rather than, as with discretionary investing, throughout the entire investment process. Systematic investing should begin with a credible hypothesis. Investors ask themselves why their investment idea would lead to excess returns, why the market has failed to price this in and what inefficiency or liquidity provision is the investor targeting? And then ruthlessly seek out data to capture these dimensions.
Not really, but they represent a growing segment of active fixed income investing. Currently about US$120 billion, but that amount is dwarfed by the total size of the fixed-income market, although it is worth noting that it has expanded by more than US$50 billion during the last five years.
There are two possible explanations for this relatively insignificant current position, one pessimistic and one optimistic. The pessimist might say the lack of popularity of systematic approaches speaks to the relative inefficiency of that approach.
But the optimist would note that while systematic fixed income investing practice is perfectly sound, it can be challenging to implement successfully. And this implementation challenge is a major obstacle persuading asset owners not to adopt systematic approaches in fixed income. For the brave and the willing, this is a huge opportunity.
Identifying sources of informational inefficiencies or liquidity provision that underpins both discretionary and systematic investment approaches, is ultimately where discretion resides.
The systematic investor then seeks to codify that investment intuition and “road test” the investment idea to see if it reliably predicts future returns, using as many different markets and time periods as possible. Implementation efficiency is critical. What are the practical obstacles in terms of transaction costs, for example? Many ideas that read well on paper cost too much to implement. A necessary condition to assess implementation efficiency is reliable data on pre and post trade price transparency and associated volumes and willingness of market participants to maintain two-sided markets. Consequently, not all fixed-income markets are suitable for the application of systematic investment techniques. Two examples would be the municipal bond market and the market for mortgage-backed securities, where this type of data is much harder to source.
It should be remembered that simply because two (or more) managers are applying systematic investment techniques, that does not mean their portfolios will be identical, any more than is the case with discretionary managers.
First, the investor needs to identify the different sources of risk premia that are on offer in their designated ‘sandbox’. For example, a fixed income investor benchmarked to an Aggregate index can harvest (i) the ‘term premium’ from investing into various government bonds, (ii) the ‘credit premium’ by investing into various credit-sensitive assets (e.g., corporate bonds), and (iii) the ‘prepayment premium’ form investing into securitized assets where investors face the risk of early prepayment of principal. Each of these risk premia have been well compensated over time and it is also possible to time your exposure to these premia.
‘Systematic Fixed Income: An Investor’s guide’ contains a comprehensive treatment of (i) the strategic asset allocation benefits of long-term exposures to the term premium, credit premium, and prepayment premium, and (ii) the potential tactical asset allocation benefits from timing exposures across these fixed income market risk premia.
Second, the investor needs to identify which fixed income assets within each of the above categories (i.e., government bonds corporate bonds, and securitised bonds) is most attractive. This is also called security selection. A systematic approach will generate exposure to securities that are attractive across well-established characteristics.
‘Systematic Fixed Income: An Investor’s guide’ contains separate chapters dedicated to the security selection insights employed by systematic investors in developed market government bond markets, corporate bond markets, and emerging market bonds. A common thread connects the return forecasting potential across these fixed income securities. Measures linked to valuation (preferring cheap over expensive securities), momentum (preferring recent winners over recent losers), carry (capturing expected returns if the shape of yield curves remain unchanged), and defensive (preferring securities from safer and higher quality issuers) can be captured across public fixed income markets.
‘Systematic Fixed Income: An Investor’s guide’ shows that aggregating exposures value, momentum, defensive, carry, and other investment themes, generates compelling excess of benchmark returns across public fixed income markets. Perhaps most interesting to asset owners is the potential for a systematic investing approach to provide exposure to these investment themes without falling guilty of the pervasive reaching for yield tendency that pervades most of the active fixed income investing approaches. The systematic approach has the potential to be a powerful diversifier – offering excess of benchmark returns that are not correlated with traditional market risk premia (i.e., alpha).
Of course, nothing is easy as an active investor in any market. There are variety of implementation challenges that need to be overcome to be a successful investor including (i) identifying/sourcing relevant data, (ii) combining that data to form measures of expected returns, risks and expected trading costs, and (iii) optimally blending those inputs with a comprehensive understanding of liquidity provision. In ‘Systematic Fixed Income: An Investor’s guide’, Richardson clearly lays out each of these dimensions, and opens the ‘black box’ of systematic fixed income investing. A new, diversifying, investing paradigm awaits asset owners.