The growth of passive investing in the equity market has been one of the defining features of the investment industry over the past decade. Now, a similar dynamic is starting to emerge in the fixed income space, with almost a quarter of assets in bond funds in Europe invested in index-tracking mutual funds and exchange-traded funds (ETFs).
The appeal to allocators of passive fixed income is clear. Many work within tight fee budgets and every basis point counts.
But the all-passive approach can make it harder for allocators to differentiate their propositions and take advantage of more volatile environments (not to mention keep up with the benchmark return).
Consequently, there is a mounting desire to squeeze more out of fixed income allocations, in the same way that many allocators have turned to smart beta to boost returns from their passive equity exposures.
One route to enhancing cost-effective fixed income returns could be systematic, or quantitative (‘quant’), credit. Quant credit is an investment strategy that embraces intuitive, fundamentally oriented processes grounded in firm economic intuition while using alternative data sets that, up until this point, have largely been non-existent in more traditional fixed income strategies.
The goal is to use these inputs to evaluate credit risk and identify investment opportunities across fixed income markets. It employs a data-driven, systematic approach to manage a broadly diversified portfolio.
Quant credit remains a niche investment area compared to its equity counterpart, largely because bonds have historically been traded over-the-counter rather than on an exchange. This has meant that, relative to equities, bonds have been less liquid, more expensive to transact and less visible in terms of price.
All that is changing, however, as the electronic trading of fixed income becomes increasingly prevalent.
Tipping point
Quant investing has radically altered the investment landscape in equities, partly driven by the move to electronic trading in the 1980s and ’90s. Quant credit, by contrast, has lagged. The reasons are manifold. The great financial crisis of 2008, for instance, emerged from the credit market, stifling innovation for many years.
The predominance of large institutional investors in the bond market, whose concerns extend well beyond credit risk, has also slowed progress. Perhaps as importantly, it is simply a hard asset class to trade electronically, with many securities from single issuers, lots of different risk characteristics and less liquidity generally versus equities.
In recent years, though, we have reached a tipping point. The percentage of trades being executed on electronic platforms has grown substantially across fixed income markets, giving credit investors more real-time price discovery, fast execution and much improved liquidity.
A key appeal of systematic credit is that, like quant equity, it offers formidable processing power. Fixed income benchmarks can contain thousands of securities, so the ability to process dozens of databases and hundreds of data points 24/7 is a significant advantage.
Using the growing amount of data generated by the fixed income and credit markets (and the wider world) helps strategies get ahead of business trends and rating transitions, among other factors that influence a security’s price and credit risk.
Isolating and trading this risk at speed, using new and innovative data sets, is what we believe lies behind quant credit’s ability to deliver attractive returns uncorrelated to discretionary fixed income.
The greatest challenge to systematic strategies breaking through in credit has traditionally been execution and the ability to model transaction costs and liquidity with a historically manual process.
However, these barriers are considerably less today, as credit execution has witnessed a massive evolution from voice trading to portfolio trading to fully electronic execution.
In addition, many quant credit strategies have proven track records spanning numerous years, which means an allocation no longer requires a leap of faith.
Evolving access
We believe that allocators will increasingly seek to blend discretionary strategies with custom systematic credit allocations. The appeal here is twofold.
One is that it provides diversification of process – investors are not solely reliant on discretionary or systematic managers. The other is that it allows fee-constrained allocators to maintain exposure to the best active bond managers, something they may otherwise struggle to do.
If they can combine a higher tracking error discretionary allocation with, say, a lower tracking error, more risk-controlled systematic credit strategy, they may enhance portfolio returns within a lower overall fee level.
Indeed, we are already beginning to witness an incipient trend in the wealth channel whereby allocators request from a single asset manager a blended solution within a set budget.
Given the breadth of strategies required, this is not something all asset managers can offer. Moreover, implementing blended solutions, which, among other factors, must consider the varying risk-return and volatility parameters of each client, requires dedicated resource.
But it demonstrates that demand for innovation is not going to abate. Just as equity markets were transformed by electronic trading, credit markets are increasingly lending themselves to quant strategies that offer far more than passive exposure to debt-weighted bond benchmarks.
As competition in the wealth market intensifies, allocators seeking to stand out from the crowd might want to consider how quant credit could work for them in a modern portfolio proposition.
Lee Matthews is managing director, head of UK retail sales at Man Group. The views expressed above should not be taken as investment advice.