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Factor investing – a source of diversification for fixed-income investors

BNP Paribas Asset Management

In addition to its relevance to equity markets, smart beta – particularly factor investing – can be applied successfully to fixed-income markets. This is a fundamentally different approach that complements traditional investment management. The traditional approach to fixed-income investment generally involves actively managing duration (i.e. the portfolio’s sensitivity to changes in interest rates), credit risk and currency exposure – three parameters that can be characterised as directional risks.

Factor investing:  the characteristics

In factor investing, however, the aim is to exploit other drivers of market performance. For example, in the case of corporate bonds, factor analysis is applied to the systematic selection of securities, which is mainly based on the assessment of issuer quality or valuation and trend indicators.

These factors have been covered extensively in academic research due to their capacity to explain long-term returns. They are based on intuitive, rational concepts that have been used by active portfolio managers for decades – albeit in a more informal, less disciplined way.

Why invest in factors

Factor strategies are now increasingly popular with insurers thanks to the numerous possibilities they offer.

  • As such, multi-factor solutions can be used within the core allocation to achieve a greater degree of style diversification than is possible with more traditional active strategies.
  • Asset allocators can use factor-based instead of passive strategies to build the main components of their portfolios and implement their top-down views.
  • Lastly, these strategies can be applied to absolute-return products.

It is therefore possible to offer purely non-directional investment solutions (whose performance is decorrelated from that of the markets) in government bonds and generate diversified returns without adding any significant duration, credit or liquidity risk.

An attractive alternative

In the current environment, with interest rates slated to rise, these solutions can be an attractive alternative to traditional fixed-income strategies.

Backed by its expertise in the research and development of quantitative strategies, BNP Paribas Asset Management has been offering multi-factor strategies in government bonds and currencies since 2009, adding corporate bonds more recently. This range of solutions applies the same factor-based investment approach to all the main segments of the fixed-income market.

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