Factor-Based Investing Beats Active Management for Bonds

Factor-driven investing, while highly popular among equity investors, has not been as widely adopted in the bond market. But research shows that a factor-based approach to bond investing is superior to attempting to identify top-performing active bond managers.

Professors Eugene Fama and Ken French are best known for their 1992 study, The Cross-Section of Expected Stock Returns, which led to the development of the three-factor equity model (market beta, size and value), the four-factor equity model (adding momentum) and the six-factor model (adding profitability and investment). Less known 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.

Recently, other factors have been proposed as adding explanatory power to bond returns. For example, in their 2018 study, Style Investing in Fixed Income, published in The Journal of Portfolio Management, Jordan Brooks, Diogo Palhares and Scott Richardson of AQR Capital Management identified four fixed-income style premiums:

  • Value: the tendency for relatively cheap assets to outperform relatively expensive assets;
  • Momentum: the tendency for an asset’s recent performance to continue in the near future;
  • Carry: the tendency for higher-yielding assets to outperform lower-yielding assets; and
  • Defensive (quality): the tendency of safer, lower-risk assets to deliver higher risk-adjusted returns than their low-quality, higher-risk counterparts.

They found that applying the four style premiums identified in other asset classes would have enhanced returns in various fixed-income markets over the past two decades. They concluded: “Our empirical analysis suggests a powerful role for style-based investing in fixed income.”