Characterising Investment Styles in Fixed Income Markets€¦ · Characterising Investment Styles...

STRICTLY PRIVATE AND CONFIDENTIAL ©

Characterising Investment Styles in

Fixed Income Markets

Vasant Naik

Head of FI Quantitative Strategies

May 2010

Fixed Income Quantitative Strategies

Vasant Naik [email protected]

Srivaths Balakrishnan [email protected]

Mukundan Devarajan [email protected]

Tom Andrews [email protected]

Research team

Overview

Top-down investment styles in Fixed Income markets

Long sample unconditional performance of investment styles

Macro properties of returns of investment styles

Comparison of Fixed Income Styles with those in Equity markets

©

Top-down investment styles in

Fixed Income Markets

Top-down Investment Styles

Source: Nomura Research

Classification of Top-down Investment Styles in Fixed

Income Markets

Price MomentumReturn continuation

Macro MomentumPersistence of macro regimes

Carry

Random walk in asset prices

Value

Mean reversion from extremes

in asset prices

Interest rates Corporate Credit Currencies Commodities

Fixed income asset classes

Top-down Investment Styles in Fixed Income (contd.)

Price Momentum:

Buy assets with strong returns against those with weak returns

Macro Momentum:

Buy risky assets in periods of economic strength and less risky ones in periods of

economic weakness

Carry:

Rates: Buy bonds when yield curves are steep

Credit: Buy corporate credit when credit curves are steep

Currencies: Buy currencies with high interest rates against those with low interest rates

Commodities: Buy backwardated commodities and sell those in contango

Value:

Buy when prices are significantly below fair value and sell when they are above

The Performance of Momentum and Carry-based

Strategies is Stronger than that of Value


All performance numbers are for volatility-adjusted investment strategies and are before transactions costs

1. Hit ratio is defined as the proportion of months with strictly positive excess returns

Momentum Carry Value

1976-2010

Average annual excess returns (%) 3.3 1.4 0.5

Annualised information ratio 1.47 0.77 0.26

Skew 1.4 -0.4 -1.5

Hit Ratio(1) 72% 63% 57%

1990-2010



Skew 1.5 -1.0 -2.0

Hit Ratio(1) 72% 63% 57%

Performance of investment styles: 1976 – 2010

Correlation between Style-based Strategies is not

Markedly High...


Momentum and Carry Momentum and Value Carry and Value

Full Sample Correlation

(1976-2010)7% -18% 41%

Median of rolling 5-year correlations

1981-2010 3% -25% 45%

1990-2010 3% -31% 53%

1999-2010 -4% -43% 46%

2007-2010 0% -26% 3%

Correlations between style-based strategies

...which Prompts their Application as a Portfolio of

Style-based Investments


All performance numbers are before transactions costs. The portfolio is constructed with the following risk weights:

Momentum 50%, Carry 25%, Value 25%

1. The actual excess returns for 2008 are 7.1%. The chart has been truncated at 6% for improved readability.

1976-2010

Avg. ex. returns (% pa) 2.1

Ann. information ratio 1.60

Skew 1.4

Hit Ratio 71%

1990-2010

Avg. ex. returns (% pa) 2.1

Ann. information ratio 1.59

Skew 1.2

Hit Ratio 70%

-1%

0%

1%

2%

3%

4%

5%

6%

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

Annual performance profile(1)

Returns of Style-based Strategies Also Help Attribute

Risk Exposures of Portfolios

Source: Nomura Research, HFRI, CS Tremont, Bloomberg

***, **, * represent significance at the 97.5%, 95% and 90% levels

Momentum ( ) Carry ( ) Value ( ) R2

HFRI Fund of Funds Wtd. Composite -1.0*** 0.7*** 0.0 16%

CS Tremont Managed Futures 1.8*** 1.7*** -1.3*** 25%

HFRI Macro Systematic Diversified 0.2 0.7*** -0.5** 4%

HFRI Relative Value -0.9*** 0.3** 0.2 29%

HFRI Event Driven -1.2*** 0.6*** 0.0 19%

Regression of Hedge Fund Index excess returns on those of style-based portfolios (1990-2010)

t

Value

tV

Carry

tC

Mmtm

tM

Portfolio

t rrrr

M C V

©

Macro properties of style-based

investment strategies

Momentum and Carry Trades Perform well in

Economic Expansions...

Source: Nomura Research, NBER. We define early and late periods of expansions as their first and second calendar

halves.

Annualised information ratios of style-based portfolios in Expansions

1976-2010 Momentum Carry Value

Full Sample unconditional 1.47 0.77 0.26

Expansion periods 1.60 0.79 0.18

Early expansions 1.64 0.90 0.31

Late expansions 1.58 0.70 0.07

-10

0

10

20

Dec-78 Nov-81 Nov-84 Nov-87 Nov-90 Nov-93 Nov-96 Nov-99 Nov-02 Nov-05 Nov-08

NBER Recessions Momentum Carry Value

Rolling three-year excess returns (%)

...while the Performance of Value Trades is Largely

Restricted to Periods of Economic Weakness

Source: Nomura Research, NBER We define early and late periods of recessions as their first and second calendar

halves.

Annualised information ratios of style-based portfolios in Recessions


Full Sample unconditional 1.47 0.77 0.26

Recession periods 1.36 0.65 0.68

Early recessions 2.13 1.61 0.81

Late recessions 0.40 -0.49 0.53

-10

0

10

20

Dec-78 Nov-81 Nov-84 Nov-87 Nov-90 Nov-93 Nov-96 Nov-99 Nov-02 Nov-05 Nov-08

NBER Recessions Momentum Carry Value

Rolling three-year excess returns (%)

The Underperformance of Momentum in Late

Recessions is Broad-based...

Source: Nomura Research, NBER We define early and late periods of recessions and expansions as their first and

second calendar halves.

Annualised information ratios of Momentum portfolios by sub-style and by asset class

Momentum by Sub-style Momentum by Asset Class

1976-2010 Price Macro Interest Rates Credit Currencies Commodities

Full Sample 1.15 0.98 1.14 0.42 1.02 0.73

Expansion periods 1.25 1.05 1.22 0.36 1.12 0.67

Recession periods 1.04 1.30 1.28 0.70 0.75 1.06

Early recessions 1.68 2.28 1.82 1.52 1.26 1.80

Late recessions 0.17 0.14 0.72 -0.59 0.0 0.15

...while that of Carry in Late Recessions is Attributable

to Asset Classes Other than Currencies

Source: Nomura Research, NBER We define early and late periods of recessions and expansions as their first and

second calendar halves.

Annualised information ratios of Carry portfolios by asset class

Carry by Asset Class

1976-2010 Interest Rates Credit Currencies Commodities

Full Sample 0.43 0.38 0.36 0.50

Expansion periods 0.59 0.36 0.43 0.40

Recession periods -0.08 0.46 0.06 1.01

Early recessions 0.10 1.92 -0.80 1.93

Late recessions -0.35 -1.31 1.63 -0.14

Regimes of Monetary Easing are Favourable for Value

Investments


Monetary Tightening

regime

Average quarterly excess return (bp) 92 54 -2

Annualised information ratio 1.84 1.02 -0.05

Monetary Easing

regime

Average quarterly excess return (bp) 71 35 49


Source: Nomura Research, Bloomberg

Note: We divide the history into three equally sized buckets based on the average of normalised quarterly changes in

policy rates across the G-7 economies. We then present the average same-quarter excess returns and information

ratios of the investment strategies based on Momentum, Carry and Value styles in the top and bottom buckets.

These Macro Properties are Reflected in their

Correlation with Bond Markets...


Correlations have been computed using quarterly excess returns. Excess returns of the US Treasury index are over

cash.



(1976-2010)28% -26% -6%


1981-2010 43% -26% -6%

1990-2010 15% 46% -11%

1999-2010 51% -15% -36%

2007-2010 53% -19% -32%

Correlations between style-based portfolios and US Treasury 1-10yr Index Excess Returns

... And with Equity Markets


Correlations have been computed using quarterly excess returns. Excess returns of the S&P 500 index are over cash.



(1976-2010)-28% -2% 11%


1981-2010 -20% 6% -1%

1990-2010 15% -23% 11%

1999-2010 -43% 14% 27%

2007-2010 -43% 14% 16%

Correlations between style-based portfolios and S&P 500 Excess Returns

In Periods of Heightened Investor Risk Aversion

Momentum Outperforms while Value Underperforms


Note: We divide the history into three equally sized buckets based on the quarterly changes in the VXO Index. We

then present the average same-quarter excess returns and information ratios of the investment strategies based on

Momentum, Carry and Value styles in the top and bottom buckets.


Low risk aversion



High risk aversion

Average quarterly excess return (bp) 117 29 -7

Annualised information ratio 1.57 0.42 -0.08

This Pattern in Observed in Regimes of Tightening

Credit Conditions as Well


Credit Easing



Credit Tightening




Note: We divide the history into three equally sized buckets based on the quarterly changes in the spread between 3

month Commercial Paper and 3 month treasury bills. We then present the average same-quarter excess returns and

information ratios of the investment strategies based on Momentum, Carry and Value styles in the top and bottom

buckets.

©

How do Styles in Fixed Income

Compare with those in Equity

Markets?

The Evidence for Persistence is Stronger than

Reversion to ‘Fair’ Value in Equity Styles as well

Source: Nomura Research, Kenneth French Data Library

Data for US Equities alone. Performance shown is that of volatility-adjusted strategies before transactions costs.

Equity ‘Carry’ : Buy top 30% stocks by Dividend/Price and sell bottom 30%.

Equity ‘Value’ : Buy bottom 30% stocks by prior long term return and sell the top 30%.

Equity Momentum Equity „Carry‟ Equity „Value‟

1976-2010



Skew -0.75 -0.01 0.20

Hit Ratio(1) 64% 50% 53%

1990-2010

Average annual excess returns (%) 14.0 -0.6 7.9

Annualised information ratio 0.62 -0.03 0.39

Skew -0.77 0.23 0.58

Hit Ratio(1) 62% 49% 56%

Performance of Equity investment styles: 1976 – 2010

Performance of Equity Styles is not Highly Correlated

with that of Fixed Income Styles...




(1976-2010)14% -4% -5%

Median of 5-year rolling correlations

1981-2010 13% -2% -4%

1990-2010 16% -8% -15%

1999-2010 13% -21% -9%

2007-2010 21% -19% -5%

Correlations between style-based portfolios in Equities and Fixed Income

...but their Macro Properties are Somewhat Similar

Source: Nomura Research, NBER, Kenneth French Data Library

Note: We define early and late periods of recessions and expansions as the first and second calendar halves

respectively, of such periods

Annualised information ratios of investment styles in Equities

1976-2010 Equity Momentum Equity „Carry‟ Equity „Value‟

Recession period

Early recessions 0.77 0.93 0.70

Late recessions -0.70 -1.53 0.52

Expansion period

Early expansions 0.91 0.36 0.13

Mature expansions 1.02 -0.30 -0.05

Full Sample 0.74 0.00 0.16


Equity ‘Carry’ : Buy top 30% stocks by Dividend/Price and sell bottom 30%.

Equity ‘Value’ : Buy bottom 30% stocks by prior long term return and sell the top 30%.

(%, p.a.) Equity Momentum Equity „Carry‟ Equity „Value‟

2007 50.1 -19.8 -48.1

2008 30.5 26.2 7.4

2009 -62.3 -21.2 5.1


Annualised volatility (%) 21.1 18.8 19.8

It is Well-known that Equity Momentum Outperformed

in 2007-08 while Value did so in 2009

Recent performance of style-based investment strategies: 2007-2009


(%, p.a.) Momentum Carry Value

2007 3.3 1.5 -2.8

2008 13.9 2.8 -2.2

2009 -0.7 -0.8 3.2


Annualised volatility 2.2 1.9 2.0

Fixed Income Styles Exhibited a Similar Pattern

During the Recent Crisis

Recent performance of style-based investment strategies: 2007-2009

©

Conclusions

Conclusions

We classify investment styles in Fixed Income markets into those based on (a)

Momentum, (b) Carry and (c) Reversion to fair value

In the long historical sample, we find that the performance of Momentum and Carry

is robust while that of Value is relatively weaker

Momentum and Carry trades perform well in Early recessions while Value does so

in Late Recessions

Similar unconditional and macro properties of investment styles are observed in

the equity markets as well

Analyst certification

We, Vasant Naik and Mukundan Devarajan, hereby certify (1) that the views expressed in this report accurately reflect my personal views about any or all of the subject securities or issuers referred

to in this research and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views contained in this research.

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