As the bond bull market grinds on, investors increasingly see fixed income as fertile ground for factor investing.
“Factors” are broad characteristics of securities, such as volatility, momentum, and quality, that can be quantified and harnessed to achieve a better performance than benchmarks. The strategy has mostly been applied to stocks, not fixed income – out of a total $900 billion in factor exchange-traded funds, only $13 billion is in fixed-income, according to FactSet data – but that may be set to change. An annual factor investing survey from Invesco found 70% of institutional investor respondents said they believe factor investing “can be extended to fixed income” in 2019, up from 62% last year.
In part, that’s because investors are realizing that whether or not their fixed income portfolios explicitly use a factor approach, their returns are “implicitly driven by exposure to factors,” Invesco noted.
Related: What is factor investing?
What’s driving interest in the factor strategy? There’s a growing recognition that “bond market efficiencies” and the many decades of declining yields make actively managing a bond portfolio a better proposition than indexing it, Invesco noted.Yield/carry, liquidity, value, and quality are the characteristics best-suited for factor approaches, respondents said.
Invesco notes two scenarios for fixed-income investing that can be achieved with a factor approach:
Investors can scoop up additional yield by using factors to identify bonds that are less liquid: from smaller issuances, say, or of older vintage.
Another example is offered by “fallen angel bonds,” those that have been downgraded because of deteriorating credit conditions, and may be picked up for lower prices, and higher yields.
Despite growing appreciation for the wisdom of fixed-income factor investing, there’s still “a shortage of appropriate products,” Invesco noted. Nearly nine in ten survey respondents said fixed income isn’t well covered by factor products. “This reflects quality as well as quantity,” Invesco noted.
The three largest ETFs that take a fixed-income “smart beta” approach (a well-known synonym for “factor”) are Invesco’s Emerging Markets Sovereign Debt ETF, PCY, -0.24% the FlexShares iBoxx 3 Year Target Duration TIPS Index Fund TDTT, +0.10% and the VanEck Vectors Fallen Angel High Yield Bond ETF ANGL, +0.10%.
See: What is asset allocation?