Disappointed with fixed income performance? Scientific investing may help

As low yields, lack of diversified returns and disappointing investment incomes plague fixed income investors, scientific investing could offer a clearer way to find advantages in an evolving and often opaque market.

At the Investment Magazine Fiduciary Investment Conference, Benjamin Brodsky (main picture, right), chief investment officer at BlueCove, outlined how scientific investing could assist many investors who have been disappointed with fixed income fund manager performance in recent years but haven’t found alternatives.

Brodsky said the traditional hub-and-spoke model where a central portfolio manager is surrounded by analysts and traders often works well, but that manager must be adept at every step of the investment process.

The scientific process, on the other hand, distinguishes itself by breaking the investment process down into its component parts (universe definition, data sourcing, alpha sourcing, portfolio construction, trade execution) and reassembling it – with people and technology assigned optimal roles.

Human discretion is focused away from its weaker fields, like subjective forecasting, and instead towards those where it’s stronger, like objective analysis.

Brodsky credits Richard Grinold and Ronald Khan at BGI for developing the fundamental law of active management: to generate sustainable excess returns you need to have skill, and then apply it to as many independent decisions as possible.

“This scientific approach in fixed income offers a differentiation and means we can apply those insights to a very large number of names and offer an uncorrelated approach and distinctive portfolio construction process,” Brodsky said.

As fixed income and equities continue to move in tandem, Brodsky suggested there was a great opportunity to take advantage of the inefficient fixed income markets.

“They offer great alpha generation capacity here and few crowding issues,” he says.

But there are still obstacles. There are still a lot of infrastructure and analytics to be developed and fixed income securities are more complex than equities, as they’re not as transparent nor as liquid.

Darren Wills (main picture, left), managing director, APAC head of fixed income iShares and Institutional Index at BlackRock, said the opportunities for fixed income investors existed but they must be prepared for risk.

Wills warns investors who are moving out on the fixed income risk spectrum, from government bonds to investment grade corporates to high yield, must be aware their correlation to equities increases each time.

“That’s the bond paradox,” he says. “As your overall portfolio gets riskier, the bonds within it might need to be more conservative.”

As such, aggressive multi-asset portfolios with higher equity allocations may still need duration or interest-rate risk options and should look to high quality fixed income assets to deliver that equity diversification, Wills said.

But as interest rates plumb record depths and fixed income assets have trended alongside equities, investors should rebase their expectations.

“There’s still value in credit assets in high yield within emerging markets and investment grade credit, but certainly the expected returns going forward are going to be more constrained,” Wills says.

One recurring discussion in fixed income circles is the wariness around perceived liquidity risks that accompany a move towards corporate, emerging market and junk bonds and can affect the different implementation techniques.

“It’s certainly a common myth that while indexing works in equity markets, somehow bonds are different and that fixed income index funds or ETFs that track those benchmarks are inherently inefficient,” Wills said, pointing out that fixed income index funds often have lower turnover and subsequently incur lower transaction costs.

“But the underlying index as well as active managers fall into that category.”

Wills said there were opportunities for all kinds of investors across the fixed income markets, but the real question is whether active managers can make the right decisions in their issuer selection to add value for clients.

“The data tells us that some do but others definitely don’t,” Wills said. “Do they have the required resources and government expertise to understand the investment process and then potentially rotate between them if the situation changes?

“If not, then an index strategy could be a pretty good solution.”

This article originally appeared on Investment Magazine.

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