Why Machines May Replace Active Bond Managers

Active bond fund managers’ outperformance is largely explained by factors, according to Invesco. These factorscould be replicated by a machine.

Luke MacGregor/Bloomberg

Luke MacGregor/Bloomberg

A machine could soon replace your bond fund manager.

According to new quantitative research from Invesco, the majority of excess returns generated by a large sample of U.S. bond funds can be explained by their exposure to factors, not the specific skill of the portfolio manager. Funds designed to systematically capture factors, characteristics of securities that can explain long-term excess returns, have become increasingly popular in equity markets. But factor-based funds are still relatively new to the bond fund world, in part because there isn’t as much academic research to support fixed-income factors.

The Invesco study found that, on average, factor exposures explained 66 percent of bond managers’ excess returns. Invesco examined data on 65 of the largest asset managers in Lipper’s “core plus” category between January 1, 2007 and June 30, 2018. Researchers looked at the returns from factors — including value, carry, liquidity, and quality — for each fund in the group. The value factor identifies bonds priced lower than peers; carry identifies higher-yielding bonds; the liquidity factor explains risk-adjusted excess returns from holding less liquid bonds; and quality refers to the return benefits of holding low volatility bonds.

“You have a situation where a lot of active managers in equities are struggling, but bond managers have been able to beat their benchmarks. We wanted to know, what explains the performance gap?” said Jay Raol, director of quantitative research in Invesco’s fixed-income unit and co-author of the study, in a phone interview.

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Over the 12 months through June, only 36 percent of active U.S. equity funds outperformed their benchmarks, according to Morningstar. But more than 70 percent of intermediate-term bond funds outperformed their passive indexes over the same time period, the investment research firm found.

Invesco’s research counters that the statistic of 70 percent of bond fund managers outperforming their benchmarks is misleading to investors.

In its study, called “Active Bond Returns – Powered by Factors,” Invesco found that the majority of bond managers have beaten their benchmarks by holding older, smaller issue size bonds, with lower ratings and longer maturities. These managers haven’t beaten their benchmarks by acting on unique investment insights. The alpha stems from their funds’ exposure to the value, carry, liquidity and quality factors, explained Raol.

Invesco also found that managers provided high returns in part by investing in securities that were cheap relative to their sector and ratings peers.

According to the report, ratings downgrades are one example of how portfolio managers use the value factor. Bonds tend to lose value before a credit ratings agency announces a downgrade. But they also on average tend to recover afterwards, depending in part on the overall economic environment.

“This risk-return tradeoff is the basis of factor investing,” Raol wrote in the report.

He explained that investors intuitively know that managers can take advantage of market conditions, such as providing liquidity when insurance companies, central banks and others are forced sellers.

“Everyone is a factor investor whether they realize it or not. That raises important questions for investors like which factors should they have exposure to and how much should they pay for these factors,” said Raol.