For investors building a fixed-income portfolio, there has historically been two approaches. One approach is to passively track a benchmark index, such as the Bloomberg Aggregate Bond Index. The other approach is to select bonds for the portfolio using an active human touch. Both strategies and investment styles have pros/cons and can deliver different results depending on market conditions.
But what if there was a way to deliver the best of both worlds?
Systematic income investing hopes to do just that. By applying data-driven, active strategies and factors to a passive index, systematic investing aims to replicate results consistently. And so far, the results have been impressive. For investors, the future of bond investing may not be active or passive, but systematic.
The Problems With Passive & Active Bond Portfolios
Building a portfolio of fixed-income securities can be a difficult proposition for many investors as both passive and active strategies have drawbacks at different times.
The problems with passive funds are easy to see.
Many bond indices, like the Agg, are weighted based on the amount of debt outstanding. Firms with the most debt tend to have a higher ranking in the index. Additionally, many bond indexes that passive funds use are specifically designed to include only the largest bonds or those that are easily traded (highly liquid). This allows them to only capture some of the overall bond universe or only a portion of a fixed-income subsector. The result is that they sacrifice illiquidity premiums from the smallest, least accessible issuers.
The end result is that passive strategies underperform in many bond subsectors.
Active management isn’t a panacea either. That’s because active managers only have a few tools at their discretion to play with to generate additional alpha. This can include credit analysis and duration assumptions.
Duration assumptions and changes to interest rates or the yield curve are unreliable. Just look at today. Go back about a year ago and many bond analysts were predicting that the Fed would have cut rates a few times by now. But the Fed has paused rate cuts for some time. Because of this, many bond analysts will go deep into credit analysis to develop additional alpha. But here again, there is only so much they can do.
The Best of Both Worlds
But a new way of building bond portfolios is brewing, and it may be a way to have your cake and eat it, too. Systematic fixed-income investing has entered the chat.
For equities, investors may be familiar with a systematic approach. Ever since economists Fama & French completed their groundbreaking work in 1992, investors have been fascinated with factors and their equity portfolios. There are numerous fund shops, such as AQR, Research Affiliates, and DFA, that have built very successful asset management programs based on this idea.
Fixed-income markets and sub-sectors are simply larger and more complex, with greater fragmentation than equities. As such, it makes liquidity and pricing harder to discover in bond markets. The rise of analytics, data mining and more advanced technology has allowed managers to exploit various factors and triggers to build portfolios of bonds that deliver excess returns. Artificial intelligence is now quickly becoming a game changer for systematic portfolios.
Essentially, systematic fixed-income investing looks at predictive factors such as value, momentum, carry, quality, and low volatility when evaluating a bond. The model will provide a score and then rank the security. Managers then make the decision to buy or ignore the issue from their portfolios grounded in their rules-based mandate. It’s this additional handholding that differentiates active systematic investing from smart-beta indexing.
The proof is in the pudding. This chart from State Street shows how screening for value and mispriced investment-grade bonds can generate extra return over Treasuries. As you can see, bonds that exhibit “value” and are owned can generate additional returns for portfolios.
Source: State Street
Many systematic managers will utilize a variety of factors in concert with each other and employ portfolio optimization to create an ideal mix of bonds within a given mandate or subsector. This is another area where AI and data can be used to add additional alpha to the systematic portfolio.
Adding A Systematic Fixed-Income Touch
For investors, systematic fixed income can serve as a bridge to higher alpha generation, eliminating some of the hiccups associated with full active management. The use of data and quantitative analysis to inform investing decisions and create predictive outcomes for bonds can lead to higher yields and better overall returns.
The key point to consider is that every asset manager’s model and data capabilities are different. A model is only as good as the data scientists developing it. So, diversification might be key even among systematic bond exposures.
So how to get that systematic exposure? Luckily, the active ETF boom has started to bring systematic fixed-income options to a portfolio near you. There are now numerous funds —some of which are very large —that cover a wide range of fixed-income asset classes, including high-yield bonds, investment-grade corporates, and even municipal securities.
Systematic Fixed Income ETFs
These funds were selected based on their exposure to various factors in the fixed-income sector. They are sorted by their YTD total return, which ranges from -1.2% to 2%. They have assets under management between $9M and $1.5B, with expenses ranging from 0.18% to 0.50%. They are currently yielding between 4.3% and 8.3%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| HYDB | iShares High Yield Systematic Bond ETF | $600M | 2% | 7.1% | 0.35% | ETF | No |
| DFCF | Dimensional Core Fixed Income ETF | $243M | 3.2% | 5% | 0.19% | ETF | Yes |
| HYGV | FlexShares High Yield Value-Scored Bond Index Fund | $1.47B | 1.6% | 8.3% | 0.38% | ETF | No |
| PHB | Invesco Fundamental High Yield Corporate Bond ETF | $680M | 0.6% | 4.99% | 0.50% | ETF | No |
| GHYB | Goldman Sachs Access High Yield Corporate Bond ETF | $134M | 0.6% | 5.6% | 0.34% | ETF | No |
| IGEB | iShares Investment Grade Systematic Bond ETF | $557M | -1.1% | 5% | 0.18% | ETF | No |
| WFIG | WisdomTree U.S. Corporate Bond Fund | $9M | -1.2% | 4.3% | 0.18% | ETF | No |
For investors looking to bridge the divide between active and passive management for their portfolios, systematic fixed-income investing could be the answer. By using factors and other fundamentals, replicating returns and generating consistent alpha are within reach. Ultimately, adding these funds to either a traditional passive portfolio or an active one can help boost yields and performance.
Bottom Line
Both true active and passive investing have benefits. But they also have some struggles. Systematic investing hopes to overcome those issues. By utilizing factors and data mining, active managers aim to achieve better long-term outcomes from bonds. The proof is in the pudding.
