Over the past decade, multi-factor investing in corporate bonds has seen significant development. Easier access to better datasets along with an extensive body of research has enabled managers to move the dial significantly. Investors can now access robust factor-based strategies offering diversification benefits in corporate debt allocations.
As an increasing number of investors, institutional as well as wholesale, implement factor-based strategies in their portfolios or consider doing so, we undertook a study looking into the diversification benefits of adding multi-factor investments to a portfolio. Our main takeaways are as follows:
1. A different risk/return positioning
The objective of multi-factor investing is to generate alpha through security selection while building a portfolio that exhibits no hidden beta, i.e. no directional market risk, via either interest rate or credit risk. That requires the strategy to replicate the same risk profile of the underlying benchmark, both in terms of interest-rate duration and credit risk.
Exhibit 1 clearly illustrates the differing risk-return profile of the average credit portfolio: both the Morningstar and eVestment categories point to a higher risk than the benchmark. Given the positive long-term risk premium associated with duration and credit risk, it is not surprising that in order to generate performance, managers should tend to take more duration and/or credit risk than the benchmark.
In contrast, the multi-factor portfolio displays a volatility that is slightly below its benchmark, indicating that incremental return is not the result of higher risk.
2. A deeper look at the diversification benefits
For investors considering factor investing strategies, one of the first questions may be : how should I employ it, as another active strategy or in a category of its own? In other words, should investors have a strategic core allocation to multi-factor investing in their corporate bond portfolio?
To answer this question, an investors need to look at whether or not the excess returns generated by multi-factor portfolios are correlated to the excess returns from traditional strategies.
The results of our analysis show no strong structural correlation between the excess returns generated by our multi-factor portfolio versus the excess returns from traditional managers.
Exhibit 2 shows the correlations of excess returns over the full period covered in our study.
Again, the result indicates that the long-term correlations of excess returns between our multi-factor strategy and the performance from traditional managers are relatively low.
This is in line with our expectations given the difference in investment process and portfolio construction. Besides the fact that multi-factor strategies do not take any directional market positioning, they also tend to operate in a broader investment universe than a traditional manager would. A systematic investment process is able to rank a very large number of bonds or issuers while active managers usually rely on their credit analysis team who will cover fewer bonds/issuers.
3. Exploring the optimal combinations of multi-factor and traditional
The relatively low correlations in terms of excess return suggest that combining multi-factor and traditional strategies should improve risk-adjusted returns.
To determine what would be the optimal allocation between both investments, we looked at the risk return of different combinations of multi-factor and traditional, and we plotted the resulting efficient frontier charts. Each dot is a portfolio with a different combination of multi-factor and traditional investments. The labels on the chart indicate the weight of multi-factor in the mixed portfolio.
In the chart above, which displays different allocations to US investment grade using the Morningstar category as the other component of the mix, the optimal combination stands at a 55% allocation to multi-factor.
All in all, the results point to a minimum allocation of around 30% to multi-factor, so as to optimise the diversification benefits in a portfolio.
Conclusion
By combining multi-factor investments with traditional active credit allocations an investor benefits from diversification. The low correlation between these two types of credit strategy helps to improve the risk-return ratio of the investment, and diversify the excess returns over the long term. As a result, multi-factor strategies can be considered to be a useful style diversifier in credit allocations, with the ability to reduce risks and drawdowns as we observed recently during the COVID-19 crisis. The conclusion we draw for investors is that they should hold a structural allocation to multi-factor strategies.
For a full set of insights into the diversification benefits multi-factor investing can bring to your corporate bond allocation, read our study: Diversifying credit portfolios with multi-factor strategies.
