From Equity to Fixed-Income - Exploring New Frontiers and Pushing Boundaries in Factor Investing and Smart BetaLionel Martellini, Professor of Finance, EDHEC Business School, Director, EDHEC Risk Institute
EDHEC-Risk Institute is launching a strategic effort for the development and dissemination of research, education and industry partnership initiatives in the fixed-income space
Over the last 10 years or so, EDHEC-Risk Institute has been extremely active in the field of equity investing from research, education and industry partnership perspectives. Starting with a seminal paper in 2006 documenting the shortcoming of cap-weighted indices1, our team has developed a massive research effort regarding how to best harvest risk premia in the equity space. This effort has culminated in a series of groundbreaking initiatives including the 2009 launch of the FTSE EDHEC-Risk Efficient Indices in cooperation with FTSE constructed using a methodology developed by EDHEC-Risk Institute, followed by the December 2012 launch of ERI Scientific Beta. ERI Scientific Beta is an original initiative which aims to favour the adoption of the latest advances in “smart beta” design and implementation by the whole investment industry. Its academic origin provides the foundation for its strategy: offer, in the best economic conditions possible, the smart beta solutions that are most proven scientifically with full transparency of both the methods and the associated risks.
It is fair to say that the smart beta approach is now firmly grounded in equity investment practices, and the key question for an increasing majority of institutional investors is not whether one should use smart beta, but instead which and how much smart beta to use. In parallel, interest in smart beta equity products is rapidly growing in retail and private wealth management. In contrast, the concept of smart beta in the fixed-income space is still relatively less mature, despite the obvious importance and relevance of the subject. We at EDHEC-Risk Institute have decided to undertake a new major multi-year effort to develop innovative and practically useful academic research in the domain. This strategic research effort will be accompanied with a series of initiatives in terms of outreach, education and industry partnership so as to enhance the impact of the research efforts.
With interest rates at a historically low level, and expected to mean-revert back to higher levels, this might perhaps seem an odd time to increase our focus on the fixed-income space. After all, if most of the uncertainty regarding bond prices is on the downside, one might wonder whether developing new research projects and industry partnerships in the area would be of any use to asset owners. To answer this question, we argue that the need for investors to develop improved forms of bond portfolios may actually be greater today than ever before.
Bonds still are, and will always remain, critically useful in investors’ portfolios, and this is true from at least two distinct perspectives. On the one hand, bonds are not only useful ingredients in performance-seeking portfolios (PSP), where the focus is on ensuring a well-diversified efficient harvesting of fixed-income risk premia. Exploring the challenges involved in risk premia harvesting – not only from a long-only focus on the first factor (namely the level of the yield curve), but also from the perspective of other less directional or non-directional factors (i.e. the slope of the yield curve, credit risk, liquidity risk, etc.) – has become only more important with the concern over increasing interest rates in the future. Besides, bonds and other fixed-income securities are also particularly useful ingredients in liability-hedging portfolios (LHP, for institutional investors) or goal-hedging portfolios (GHP, for individual investors), where the focus is on neutralising the impact of unexpected changes in the yield curve. This problem is particularly important in a long-term retirement context, as we explain below.
The need for more efficient harvesting of fixed-income risk premia
The modern approach to factor investing suggests that we should first identify robust and economically motivated sources of risk in fixed-income markets, select securities on the basis of the desired factor tilts, and then apply an efficient weighting scheme aiming to enforce the highest level of diversification so as to eliminate as much unrewarded risk as possible from investor portfolios. In this context, it appears that more work is required both in academia and in the industry to start addressing such challenges in a careful way, before we are able to see the emergence of improved bond benchmarks that will provide adequate answers to investors' needs.
Two articles in this newsletter, a contribution by myself entitled “New Frontiers in Smart Beta Investing: Benefits and Limits of Traditional and Alternative Bond Benchmarks” and a contribution by Riccardo Rebonato entitled ”Smart Beta Strategies in Fixed Income”, will explore the benefits and challenges associated with risk premia harvesting in fixed-income markets.
The need for better bond portfolios in retirement solutions
Financing consumption in retirement has become the greatest challenge for most individuals following a number of important changes, including the weakening state pension systems (pillar I) and the shift from defined-benefit (DB) to defined-contribution (DC) schemes in the corporate world (pillar II). As a result of these changes, individual investors preparing for retirement essentially need investment solutions providing them with DB-type pay-offs (that is pay-offs allowing for a fair degree of certainty regarding expected levels of replacement income in retirement) in a DC-type environment (an environment where little, if any, formal guarantees are offered by sponsoring states and corporations).
Annuities can be used to secure replacement income in retirement but these products are unavailable early in the accumulation phase, they lack transparency and flexibility, and they are cost-inefficient due to the prohibitive cost of capital for investment banks and insurers facing increasingly strict solvency requirements. Moreover, their inherent irreversibility leaves investors with no exit strategy, unless they do so at the cost of high surrender charges. Investors in accumulation or transition phases clearly do not need irreversible insurance products. In the UK, the 2015 Pension Act, which has nullified the compulsory annuity purchase, creates a tremendous opportunity for asset managers to launch meaningful forms of retirement solutions.
A key ingredient in these retirement solutions is the development of a novel form of fixed-income portfolios, where the key focus should be on generating inflation-linked or cost-of-living-adjusted replacement income for a period of time roughly corresponding to a significant period of time in retirement where consumption levels remain high, say between 20 and 25 years after the retirement date2. Such retirement goal-hedging bond portfolios are very different from bond portfolios mistakenly used as the risk-free asset in balanced fund or target date fund products.
Fixed-income research, education and industry partnerships at EDHEC-Risk Institute
EDHEC-Risk enjoys the privilege of being able to rely on the expertise of some of world very best experts in the area of fixed-income securities. I am particularly proud to develop research projects in fixed-income with my colleagues Riccardo Rebonato – a world leading expert in interest rate risk modelling and management who was previously Head of Research at PIMCO, Frank J. Fabozzi – author and editor of over 100 reference textbooks in finance with a main focus on fixed-income securities, and Dominic O’Kane – a specialist in credit modelling, derivative pricing and risk-management, who was Head of Fixed Income Quantitative Research for nine years at Lehman Brothers (see the article in this newsletter entitled “Learn from 4 EDHEC-Risk experts on Fixed Income Securities” for more details on fixed-income expertise at EDHEC-Risk Institute). We are also fortunate to rely on the expertise of Vincent Milhau – Research Director at EDHEC-Risk Institute, who has been involved in a number of academic and industry research projects in the area of fixed-income securities.
In addition to the aforementioned research initiatives in the area of fixed-income risk premia harvesting and implications for smart beta fixed-income indices, our team of experts also expect to launch a number of educational and outreach activities in that space. One of these initiatives is related to the launch of a retirement bond index series. This retirement goal bond index series is designed to dynamically hedge interest rate risks and realised or expected inflation risks and thus form a dynamic proxy for a forward inflation-linked or cost-of-living adjusted bond ladder. The introduction of this retirement goal index series is consistent with the prescription of asset pricing theory, which has shown that investment in T-Bills is a low volatility strategy from an absolute return perspective, but extremely risky for use in a retirement context since it leads to a highly volatile level of purchasing power expressed in terms of inflation-linked replacement income.
Against this backdrop, EDHEC-Risk Institute will seek to form partnerships with prominent asset managers or investment banks to launch related investable solutions. In a second step, dynamic asset allocation goal-based retirement indices and related retirement goal investment solutions can also be proposed, allowing investors to secure a minimum level of replacement income in retirement while generating attractive probabilities of achieving a target level of replacement income.
Overall, the whole team is really excited about the ambitious journey that we are about to start in the area of fixed-income research, education and industry partnerships. Our motto – “academic roots and practictioner reach” – summarises what we are trying to accomplish, namely provide academic guidance to the investment industry so as to help facilitate the emergence of welfare improving forms of investment solutions.
1 Amenc, N., F. Goltz, and V. Le Sourd. 2006. Assessing the Quality of Stock Market Indices: Requirements for Asset Allocation and Performance Measurement. EDHEC-Risk Publication (September)
2 In parallel, late life annuities can be purchased in decumulation so as to generate protection against tail longevity risk. Healthcare insurance can also be added to the mix so as help individuals deal with increasing healthcare costs in late retirement