New Research on Factor Investing in the Bond Market

Factor-driven investing, while highly popular among equity investors, has not been widely adopted in the bond market. But new research shows how to construct highly efficient fixed-income portfolios using factors, as well as the ongoing importance of reducing expenses.

Professors Eugene Fama and Ken French are best known for their 1992 study “The Cross-Section of Expected Stock Returns.” Based on the findings documented in that paper, they proposed that the single-factor (market beta) capital asset pricing model (CAPM) be replaced by a new three-factor model, adding size and value, as their addition significantly improved the ability to explain the differences in returns of diversified portfolios. Less well known, perhaps because bonds are less sexy than stocks, is that in their 1993 paper “Common Risk Factors in the Returns on Stocks and Bonds,” Fama and French also proposed a two-factor (term and default) model to explain bond returns.

Marlena Lee, co-head of research at Dimensional Fund Advisors, conducted perhaps the most rigorous performance study of bond managers in her 2009 study “Is There Skill among Bond Managers?” Lee employed modified Fama-French term and default factors in combination with market, size and value factors to risk adjust alphas. Lee’s sample included 2,353 active U.S. investment-grade, high-yield and government bond funds and covered the period January 1991 to December 2008. Following is a summary of her findings:

  • In aggregate, active bond funds underperform appropriate benchmarks by an amount roughly equal to fees.
  • All categories of funds (government, corporate, high yield) produce negative net alphas.
  • There is no evidence of winner persistence in net returns beyond the randomly expected. We cannot separate skill from luck.
  • Collectively, investors in active bond funds lose about 90 basis points per year, or about $1.4 billion in 2008, in underperformance – a triumph of hope over experience.