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The quantitative revolution that put data at the forefront of picking stocks has yet to make a significant dent in bond investing — but one of the world’s most prominent asset managers says it’s trying to change that.
BlackRock Inc. BLK, -0.56% says the time has come for bond fund managers to adopt data-driven investing techniques, not only to better understand how to further boost returns, but to uncover where risks may hide in their portfolios.
“If you don’t know where your returns come from, then you don’t understand your sources of risks,” Jeffrey Rosenberg, senior portfolio manager for BlackRock’s systematic fixed-income team, told MarketWatch in a Feb. 10 interview.
Only a few large hedge funds and deep-pocketed asset managers currently use computer-driven quantitative models to break down returns into individual “styles.”
Factors, or rules-based investing, popularized in the equity markets, refer to the process of identifying specific market inefficiencies, including those like value or growth, that proponents say have gone a long way in explaining why certain stock portfolios beat their benchmarks.
Now, investors are beginning to employ that technique in bond portfolios, by focusing on factors to help decode how features like volatility and inflation drive returns in fixed-income securities.
Specifically, momentum is a commonly used style factor for equities that can also apply to fixed-income assets such as U.S. Treasurys since it includes an assumption that assets that recently have done well tend to follow an upward trajectory and add to portfolio gains.
Related: Here are four reasons why investors might snap up negative-yielding bonds
Other macro factors are broader and applicable to a wider investing universe, such as the negative impact that inflation can erode fixed-income returns, particularly when yields on a significant slice of the U.S. junk-bond market recently sunk to a record low of 3.89%.
Perhaps it’s no surprise that the bond sector, a segment of the market that has notoriously seemed behind the times, where traders had only recently opted to end the practice of conducting trades by phone, has been slow to embrace innovative approaches like factor-based investing.
Read: What is factor investing?
Though alpha is often described as the ability to beat the return of a benchmark, Rosenberg said BlackRock’s quant researchers define the term more narrowly. They describe it as the outperformance versus an index after excluding any returns that are due to investing factors.
As a result, only a sliver of the outperformance can be attributed to alpha, meaning most bond fund managers looked quite ordinary once the factor component was taken into account, he said.
BlackRock thinks taking a quantitative approach helps strengthen its own lineup of actively managed funds.
The firm’s own foray into factor investing in the bond market has its origins in the acquisition of Barclays Global Investors, or BGI, back in 2009, which saw it obtain the index investing business iShares and its specialist quantitative fund managers. Though its index business has drawn most of the attention, the quantitative capabilities gained from BGI also have been a key part of BlackRock’s strategy for boosting performance and attracting additional assets to its actively managed bond funds.
A BlackRock spokesperson said around $1.4 trillion of assets is managed under the firm’s systematic fixed-income platform, which encompasses factor investing and other strategies that make use of scientific techniques to analyzing bond market returns. This also includes the firm’s $4.6 billion Fixed Income GlobalAlpha fund, one of its biggest hedge funds.
See: BlackRock’s assets top $7 trillion for first time
Indeed, only about 1% of factor exchange-traded funds were for fixed-income as of October, according to FactSet data.
Read: Fixed-income investors are ready for factor funds, survey says
Why haven’t more asset managers embraced factors? Rosenberg thinks many fixed-income benchmarks may be too easily beat by adding credit risk, as bonds more likely to default also tend to carry much richer yields.
The lion’s share of index-beating returns from active bond fund managers in the last two decades have come from a “persistent overweight to high-yield (HY) credit,” according to a 2018 paper by AQR Capital Management, the quantitative investment manager founded by Cliff Asness.
Over the past five years, the average, active intermediate-term bond fund manager has made more money than their benchmark 57% of the time, according to a research paper by Guggenheim Partners.
“One of the first lessons my mentor portfolio manager taught me in the business was that to outperform, you need to outyield,” said Rosenberg.
“In the equity world, investors didn’t stop at understanding active returns,” or any return generated by a portfolio in excess of their benchmark, Rosenberg said, adding that underperformance drove equity fund managers to come up with quantifiable factors to explain why certain stock portfolios perform better than others.
But the same spark — the challenge to beat a benchmark — has been missing in bond portfolios where investors only need to beat low-yielding indexes, which are mostly composed of long-dated government bonds. The yield on the benchmark 10-year Treasury note TMUBMUSD10Y, -1.03% fell 2.5 basis points to a mere 1.602% on Thursday.
This approach, however, could expose investors to more risk than they bargained for, as their bond funds may not serve as ballast against stock-market downturns because they held lower-rated corporate debt that tended to move in line with equities.
Moreover, the popularity of these riskier bonds among fund managers would drive their yields lower, reducing the additional gains reaped from buying debt that was more likely to stop paying off its obligations.
Instead, a more data-driven portfolio manager would combine multiple factors when screening bond investments to amplify returns but without overly exposing the investor to any one concentration of risk.
“Most fixed-income investors have been more than willing to ignore the sources of active performance, and not go to the next level,” Rosenberg warned. “Without an obvious problem to solve, there’s not a lot of debate.”