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Fixed Income Investing - November 28, 2016

Time appears ripe for focusing on smart beta in fixed income

In this interview, we talk to Riccardo Rebonato, Professor of Finance at EDHEC Business School and Member of EDHEC-Risk Institute, about the reasons behind his decision to join EDHEC, his previous experience at PIMCO, his insights on fixed-income investing, and his current and future research projects.

Riccardo Rebonato

You joined EDHEC as professor of finance at the beginning of May. Could we ask what motivated your choice of EDHEC?

Riccardo Rebonato: Before joining EDHEC I had accumulated more than 25 years of experience in the financial industry (and had been an academic before that). I knew EDHEC well from its excellent research papers that I was reading for my professional work, and from the reputation of its faculty. I was struck by the nice combination of intellectual rigour and practical relevance of the work produced by my now-colleagues. So, when the opportunity arose to interview for a professorial position at EDHEC, I really seized the opportunity with both hands, and I am very glad to be on board.

Before joining EDHEC, you were Global Head of Rates and FX Research at PIMCO. Will that professional experience have an impact on your academic work?

Riccardo Rebonato: I have always believed that theory and practice work best together (in my previous academic life as a physicist, I use to combine theory and experiments – something that was already unusual at the time, and almost unheard of now). So, yes, I think that what I have learnt about the practice of finance and the empirical aspect of the behaviour of asset prices can be very relevant to inform my research and my teaching at EDHEC. My research focus in the industry was more geared towards identifying the best timing of various strategies – say, discovering and testing robust return-predicting factors in fixed income. My focus now is far more towards the cross-sectional analysis, but I see the two approaches as complementary, rather than in opposition. After all, a solid approach to both styles of investing is grounded in the same financial theory: the theory of how risk factors are priced. So, I really believe that what I have learnt in the industry will give my colleagues and I useful input for our work.

Fixed-income investing in a zero rate environment is a strategic area of development for our institute; what are your insights on this important subject?

Riccardo Rebonato: EDHEC-Risk Institute has a strong reputation and a first-class pedigree for smart beta investing. I find this area very exciting, and very appealing, both intellectually and practically. Recently, there has been a spate of activity in fixed-income smart beta – and, certainly, the current super-low rate environment is giving a salient topicality to the topic. In this environment, investors in general, and institutional investors such as pension funds in particular, are truly struggling to find suitable fixed-income investment opportunities: it is not just that nominal yields are so low. Despite very low inflation and inflation expectations, real yields are also extremely low (and often negative!). For pension funds, such a low yield environment is a toxic ‘double whammy’: not only do these low nominal and real yields depress expected returns on new investments, but they also increase the value of the pension liabilities (via discounting). So, providing sound and attractive investment solutions for this class of investors would be really important and socially useful.

You are a specialist in interest rate risk modelling with applications to bond portfolio management and fixed-income derivatives pricing. Could you tell us a little about your current and future research projects?

Riccardo Rebonato: In the light of the above, derivatives pricing is unlikely to be the answer for the institutional investors I referred to above. For this and other reasons, in the last few years my research focus has moved away from derivatives and exotic products in particular, and more towards the fundamental aspects of fixed-income asset pricing. What would be extremely useful in the current environment would be the identification of true risk factors in the fixed-income space, with an adequate compensation for the exposure they entail. When I say ‘true’ risk factors, I mean economically justifiable factors, and not just ‘anomalies’ (let alone artefacts of data mining). The distinction matters, because true risk premia are, broadly speaking, a compensation for being paid well in good states of the world and poorly in bad states of the world. As a consequence, by discovering a risk factor, one does not make it disappear – if the compensation has a solid economic justification, it will still be there tomorrow. Anomalies, instead, are just that – anomalies: if exploitable, once revealed, they can be arbitraged away. The process of discovering, understanding and justifying true risk factors is at the heart of smart beta investing in general. As I said, the time seems to be ripe for focusing on smart beta in fixed income. If, with my colleagues, I could make a contribution in this area, it would give me an enormous satisfaction.

About Riccardo Rebonato

Riccardo Rebonato is Professor of Finance at EDHEC Business School, member of EDHEC-Risk Institute and author of journal articles and books on Mathematical Finance, covering derivatives pricing, risk management and asset allocation. Prior to this, he was Global Head of Rates and FX Analytics at PIMCO. Academically, he is an editor of financial journals and was until recently a visiting lecturer at Oxford University and adjunct professor at Imperial College’s Tanaka Business School. He sits on the board of trustees for the Global Association of Risk Professionals (GARP). Previously, he was global head of market risk, head of research and head of complex derivatives trading for European banks. He was a Research Fellow in Physics at Corpus Christ College, Oxford, a Visiting Scientist at Brookhaven National Laboratory, and a Chercheur Invite’ at the Institute Laue-Langevin (Grenoble). He holds a doctorate in nuclear engineering (University of Milan) and a PhD in condensed matter physics/science of materials from Stony Brook University, NY.