The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

The fixed income securities market – an overlooked giant?

Man Systematic Strategies

Q1 2014

This is the second of a two-part article. The first part was published in the Q4 2013 edition of the AIMA Journal and can be downloaded here.

Momentum strategies
Directional momentum strategy – buy after positive performance, sell after negative performance
The essence of momentum as a directional strategy can be easily described: one goes long a market if it has recently gone up, and one goes short a market if it has recently gone down. Such trends frequently occur in financial markets and specialised fund managers, typically referred to as Commodity Trading Advisors (CTAs), have successfully pursued momentum strategies over the last few decades.
There are a number of explanations for the trending behaviour of financial markets. One explanation rests on the empirical finding that investors often behave irrationally. In particular, investors are generally found to exhibit herding behaviour, i.e. the tendency to follow other market participants in their investment decisions. Another explanation focuses on the fact that investors respond to new information at different speeds. For instance, on average, mutual funds or retail investors are likely to respond slower than hedge funds as their decision-making processes are typically lengthier.  
It is easy to design a simple version of a directional momentum strategy. The below implementation goes long (short) a market if its price is higher (lower) than its average price over the last year (further details can be found in the appendix). In terms of traded instruments, the natural equity candidates are stock index futures (as single stocks have too much event risk). For fixed income, there are a number of sensible candidates including government bond futures and money market futures. As long-term interest rates have experienced a single cycle only (with rates going up till 1982 and then declining), momentum trading tends to result in a pattern of being mainly short until 1982 and mainly long after 1982. We have therefore tested momentum trading on money market futures. Here, momentum trading results in a more active strategy as short term interest rates have experienced multiple cycles over the last 20 years (see Exhibit 6).

Exhibit 6: Three month USD LIBOR rate
Source: Bloomberg

Exhibit 7 shows the simulated annual returns net of estimated transaction costs. The strategy has been profitable in both fixed income and equity markets. In fixed income markets, the momentum opportunities were considerably stronger though.

Exhibit 7: Simulated returns of a simple momentum strategy

Returns have been scaled to an annualised volatility level of 10%. Source: Man

This finding may be due to luck. However, there may also be structural reasons that cause short-term interest rates to exhibit strong trends. In particular, short-term interest rates are heavily influenced by central banks; central banks tend to respond to economic fundamentals, which in turn evolve gradually in macroeconomic cycles. This could explain why interest rates are particularly suitable for directional momentum strategies.

Non-directional momentum strategy – buy previously out-performing while selling previously underperforming securities
In the academic literature, it is a well-documented empirical finding that buying previously outperforming stocks while selling previously underperforming stocks has produced abnormal returns. It is natural to extend this strategy to fixed income and to buy government bonds that have outperformed while selling government bonds that have underperformed. However, the low cross-sectional dispersion that government bonds from major countries have exhibited has presented a difficult backdrop for such strategies.

Exhibit 8 plots the average pairwise correlation over the last 10 years between bond indices of the G10 countries and between the constituents of the S&P 500. It shows that the dispersion among single stocks was structurally higher than among G10 bond indices until the financial crises in 2008. The low dispersion in price movements among government bonds created less room for trends in relative price movements to emerge, making it difficult for a cross-sectional momentum strategy to be successful.

Exhibit 8: Average pairwise correlations


Numbers computed based on a rolling six month return window. Bond correlations based on Bank of America Merrill Lynch country bond indices (7-10 year maturity band). S&P 500 constituents selected as of 31 May 2013. Source for underlying data: Bloomberg, Man database

However, the dispersion amongst G10 government bonds has increased considerably since 2008 as investors have paid more attention to the credit quality of different G10 countries, particularly within the Eurozone. As shown in Exhibit 9, government bonds from different Eurozone countries used to move in lockstep until 2008. The dispersion in yields then widened and peaked at the height of the Euro crises in 2011/12. While the dispersion has moderated since then, it is unlikely that it will return to the very low levels seen prior to 2008. This may present future opportunities for cross-sectional momentum strategies in fixed income markets.

Exhibit 9: 10 year government bond spreads over Germany

Source: Bloomberg

Overall, this leads us to an intriguing conclusion for momentum strategies: for fixed income, momentum has worked better as a directional than as a cross-sectional signal, whereas the converse appears to be the case for equity markets.


In order to gauge the number of opportunities in fixed income markets, we have analysed how different alternative fixed income strategies have performed historically, and how this compares to alternative equity strategies.

Our findings, which are summarised in the below table, suggest that fixed income markets have exhibited alternative investment opportunities. At least two of the fixed income strategies that we tested would have generated solid returns historically. In reality, fund managers will pursue more refined strategies than the ones we have tested, so our results probably underestimate the level of opportunities.

Value chart

Therefore, the fact that fixed income markets receive limited attention can likely not be explained by sparse investment opportunities in these markets.

The positive performance of our fixed income strategies appears to rest on price inefficiencies that differ from those typically discussed in the context of equities. For fixed income, opportunities arise from other price inefficiencies: our strategies capitalise on trends and transient dislocations.

With central banks and pension funds which need to match their liabilities, there exist two large players whose primary objective is not to maximise profits. Their behaviour could indeed cause trends or dislocations to emerge. Our finding that momentum as a directional signal works particularly well for short-term interest rates, i.e. in markets that are heavily influenced by central banks, is consistent with this hypothesis.

Over the last 30 years, the need for alternative fixed income investments was limited as bond markets steadily rallied. However, with interest rates being at very low levels and subject to the risk of going up, the case for exploring opportunities that go beyond a passive buy-and-hold investment approach should be strong.


Implementation of the directional momentum strategy

The strategy goes long (short) a constant amount if the price of a market is higher (lower) than the average price over the last year. The bid-offer spread has been assumed to be one tick wide for all markets. The strategy has been applied to the following stock index and money market futures:

Futures chart

The returns from trading these markets have been equally weighted in terms of their volatility contribution.

Important information
This material is communicated by Man Investments Limited (the ‘Company’), a member of Man Group plc ('Man'). The Company is authorised and regulated by the Financial Conduct Authority in the UK.
Hong Kong: To the extent this material is distributed in Hong Kong, this material is communicated by Man Investments (Hong Kong) Limited (the ‘Company’) and has not been reviewed by the Securities and Futures Commission in Hong Kong. This material can only be communicated to intermediaries, and professional clients who are within one of the professional investor exemptions contained in the Securities and Futures Ordinance and must not be relied upon by any other persons.
Singapore: To the extent that this material is distributed in Singapore, this material is communicated by Man Investments (Singapore) Pte Limited (the ‘Company’) and has not been reviewed by the Monetary Authority of Singapore.
Australia: To the extent this material is distributed in Australia it is communicated by Man Investments Australia Limited, which is regulated by the Australian Securities & Investments Commission (ASIC).
This material is for informational purposes only and does not constitute any investment advice or research of any kind. Opinions expressed are those of the author and may not be shared by all personnel of Man. These opinions are subject to change without notice. This material is for information purposes only and does not constitute an offer or invitation to make an investment in any financial instrument or in any product to which any member of Man’s group of companies provides investment advisory or any other services. Any organisations, financial instruments or products described in this material are mentioned for reference purposes only and therefore, this material should not be construed as a commentary on the merits thereof or a recommendation for purchase or sale. Neither Man nor the author(s) shall be liable to any person for any action taken on the basis of the information provided. Any products and/or product categories mentioned may not be available in your jurisdiction or may significantly differ from what is available in your jurisdiction. Some statements contained in this material concerning goals, strategies, outlook or other non-historical matters may be forward-looking statements and are based on current indicators and expectations. These forward-looking statements speak only as of the date on which they are made, and Man undertakes no obligation to update or revise any forward-looking statements. These forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those contained in the statements. The Company and/or its affiliates may or may not have a position in any security mentioned herein and may or may not be actively trading in any such securities. Past performance is not indicative of future results. This material is proprietary information of the Company and its affiliates and may not be reproduced or otherwise disseminated in whole or in part without prior written consent from the Company. The Company believes its data and text services to be reliable, but accuracy is not warranted or guaranteed. We do not assume any liability in the case of incorrectly reported or incomplete information. Information contained herein is provided from the Man database except where otherwise stated.
Past performance may not necessarily be repeated and is no guarantee or projection of future results. The value of investments and the income derived from those investments can go down as well as up. Future returns are not guaranteed and a loss of principal may occur.
Please note that all information in this document is furnished as of the date stated on the cover of this presentation, unless otherwise stated.  This document and its contents are confidential and do not carry any right of publication or disclosure to any other party. All rights reserved, Man (2013).


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