Alternative Investment Management Association
Man Systematic Strategies
The world equity and world bond markets are of a comparable size1. However, the amount of attention that opportunities in these markets receive is remarkably different:
Exhibit 1: Number of articles published by Thomson Reuters
Source for underlying data: Thomson Reuters News Analytics. Numbers computed by Man. Articles on companies have been counted as equity related unless there was at least one fixed income related key word assigned to them.
Exhibit 2: Number of papers published on SSRN
Source: Numbers computed by Man based on SSRN web search results.
Why do opportunities in fixed income markets receive so little attention? One answer could be that fixed income markets exhibit limited opportunities. However, one may also argue the converse: the lack of fixed income research could imply some untapped opportunities.
There are arguments for both points of view:
On the one hand, fixed income may indeed exhibit fewer opportunities. For equity markets, there exists a large universe of stocks and for each stock there is a wealth of publicly available fundamental information – creating plenty of room for disagreement and misevaluation. While a similar amount of information is available for corporate bonds, their liquidity tends to be limited, making it hard to capitalise on opportunities. Government bonds are liquid, but are subject to only a very limited amount of instrument-specific information – creating little room for disagreement and misevaluation.
On the other hand, the lack of attention to fixed income markets may imply that there are untapped opportunities. In fact, recent research by McLean and Pontiff has found that opportunities decay as they get publicised in the academic literature3. The authors’ choice of which anomalies to analyse is interesting: they study 82 anomalies – 82 anomalies related to equity markets and zero anomalies related to fixed income markets!
In this paper, we try to gauge the number of opportunities in fixed income markets by analysing how different alternative fixed income strategies would have performed historically, and how this compares to alternative equity strategies. Our starting point for selecting strategies is the observation that strategies can be grouped according to two criteria, namely whether a strategy predicts:
This classification leads to the following four strategy types:
For each type, we will present (reasonably simple) strategies for fixed income and equity markets. We begin with value strategies and then turn to the momentum strategies.
Non-directional value strategy – buy relatively cheaper while selling relatively more expensive securities
For equity markets, non-directional or “cross-sectional” value strategies are well documented in academic literature and commonly pursued by fund managers. The basic idea is to buy (or overweight) stocks that are cheap and to sell (or underweight) stocks that are expensive. Common value metrics are variants of the price-earnings or price-to-book ratios.
An analogue in fixed income markets would involve buying bonds from countries with high yields and selling bonds from countries with low yields. While fixed income strategies built along these lines can yield positive returns, they are susceptible to severe drawdowns as yield spreads tend to sharply widen from time to time. Such increases in yield spreads tend to affect multiple countries at the same time, making it difficult to diversify away this risk (a recent example was the selloff of peripheral European bonds in 2011/12).
Another notion of value in fixed income markets is to trade different points of a yield curve against each other, i.e. to go long points of the yield curve that are “cheap” and short points of the yield curve that are “expensive”. For example, a well established strategy is to trade the five year point against the two and 10 year point, which is schematically illustrated in Exhibit 3.
Exhibit 3: Schematic illustration of trading a yield curve
The rationale behind this “2/5/10 butterfly trade” lies in the fact that the two and 10 year points typically move in a certain relation to the five year point. For instance, if the five year point moves out of line following the issuance of new bonds, then it tends to revert back over time. Also, the carry dynamics (in the form of yield and roll-down) of the two, five and 10 year points can provide an additional source of income. This trade has no direct analogue in equity markets.
Below is a simple example of a curve trading strategy for the US and the German government bond yield curves (details on the implementation can be found in the appendix). For these two countries, there exist two, five and 10 year government bond futures, which makes implementing a 2/5/10 butterfly trade particularly easy. The strategy could be extended to other yield curves, for instance by trading interest rate swaps rather than government bond futures. Exhibit 4 shows the simulated annual returns of the strategy. The Sharpe ratio for the strategy is 0.57 net of estimated transaction costs; the correlation to a passive strategy (that is always long the five year points) is 0.22, i.e. relatively low.
Exhibit 4: Simulated returns of a simple curve trading strategy
Returns have been scaled to an annualised volatility level of 10%. Source: Man.
So it is possible to follow a value strategy in fixed income markets as well as equity markets. However, there are differences. In equity markets, there is a large universe of stocks and each stock has a large amount of fundamental information. Ultimately, a value strategy in equity markets aims to capitalise on misevaluations of this fundamental information. In contrast, the universe of countries with liquid government bonds and the amount of bond specific information is limited. However, our value strategy is able to use technical data to capitalise on transient distortions in yield curves, for instance caused by central bank action or issuance activity.
Directional value strategy – buy when historically cheap, sell when historically expensive
While also a value strategy, a directional interpretation of value has a rather different proposition than its non-directional counterpart: it reflects the view that it is possible to time the purchase and sale of an asset, i.e. to buy equities or bonds when they are cheap and to sell equities or bonds when they are expensive. This idea is frequently expressed in the media; in fact discussions addressing whether it is the “right time” to get in or out of the stock or bond markets appear to be ubiquitous.
However, in our experience it is difficult to design (reasonably simple) strategies that would have generated positive returns by timing equity or fixed income markets based on value measures. More specifically, the challenges in designing such a strategy are twofold:
First, going short is costly in both bond or equity markets as stocks and bonds generate positive income in the form of company earnings or coupon payments. Thus, even if valuations of overpriced assets revert eventually, the negative income in the meantime may well overwhelm the total returns. Second, it is easy to make statements about what level of value is “cheap” or “expensive” looking back at historical data. However, in real time, determining value is much more challenging4.
To illustrate the difficulty that one faces in building a profitable strategy, Exhibit 5 shows long-term time series computed by US economist Robert Shiller of price-earnings ratios and interest rates in the US. Equities looked expensive from the mid 1980s to 2000 compared to the historical average; yet equity markets rallied strongly over this period, causing a severe drawdown in the strategies we tested. For long-term interest rates, the challenge arises from the fact there was effectively only one cycle: interest rates went up until 1982 and then declined.
Exhibit 5: Price-earnings ratio and long-term interest rates
Data for the US as computed by Robert Shiller.
Source: Robert Shiller’s website.
In summary, it has not been easy to generate returns by timing investments based on fundamental measures of value – in either fixed income or equity markets.
Implementation of the 2-5-10 curve trading strategy
The curvature of a yield curve is measured as:
(5 year government bond rate)
- ½ * (2 year government bond rate)
- ½ * (10 year government bond rate)
The strategy takes positions in the two, five and 10 year point. Specifically, the position in the five year point is hedged with positions in the two and 10 year point, each of them having half of the opposite risk exposure of the five year point. In the five year point, the strategy goes long (short) a constant amount if µC + Carry is positive (negative), where
The bid-offer spread has been assumed to be one tick wide for both German and US bond futures. The returns from trading the two curves have been equally weighted in terms of their volatility contribution.
Part 2 of this article, which analyses momentum strategies, will be published in the next edition of the AIMA Journal.
 The market capitalisation of the Bloomberg World Exchange Market Capitalisation index (WCAUWRLD) was USD 55 trillion and the market value of the Barclays Capital Aggregate Bond index was USD 42 trillion (as of 20 March 2013).
 There are 1,027 equity and 204 fixed income (including credit) hedge funds reporting to the HFR database (as of April 2013).
 McLean, R. David and Pontiff, Jeffrey. 2013. “Does Academic Research Destroy Stock Return Predictability?”, working paper.
 For academic research on the difficulty to predict stock market returns with value measures, see: Goyal, Amit and Welch, Ivo. 2008. “A Comprehensive Look at the Empirical Performance of Equity Premium Prediction”, Review of Financial Studies, 21(4), 1455-1508.
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