Introducing a Low-Volatility Factor to High-Yield Fixed Income

Introducing a Low-Volatility Factor to High-Yield Fixed Income

For your clients seeking income, today’s environment is a tricky one. Interest rates are climbing, fixed-income yields are still low, and equities are at higher levels than they’ve ever been.


Volatility, of course, can be a killer for anyone, but that’s particularly so for investors who are past the accumulation stage and are forced to draw down on principal for their income needs. As an advisor, that presents a sizable challenge: how can you lower risk and continue to provide an attractive yield—all within a relatively short time horizon? One answer:  rebalance your client portfolios using a low-volatility strategy in the high-yield fixed income space.

Low-volatility investing is nothing new. It’s been a popular approach in the equities space for years, and there’s been solid evidence—empirically and academically—that it works well as a risk-reduction tool. But despite the success that this low-volatility approach was bringing to many investors, the strategy was largely ignored in high-yield fixed income. Why? Though the proximity of high-yield corporate bonds to equities was the logical next step, making that leap meant overcoming some significant barriers, not the least of which was figuring how to determine the volatility of bonds in the first place. Unlike equities, fixed income instruments don’t trade every day, so calculating volatility by measuring the standard deviation of price changes is difficult (to say the least). Another challenge was that, as bonds age, their duration shortens, which decreases the volatility. Credit ratings add even more complexity to the puzzle. While ratings do offer some level of information, they’re generally subjective and, as such, may be less reliable. Worse yet, these ratings simply aren’t updated frequently enough to account for recent events. After all, you need to know it’s time to get out of a bond before a credit downgrade and the spread starts widening, not after the fact!

Luckily, statisticians came to the rescue more than 15 years ago with the standard DTS calculation. DTS multiplies a bond’s duration (D) times (T) its credit spread (S) to measure a bond’s riskiness. DTS is important because it allows bonds to be ranked not by their less-than-reliable credit risk scores, but instead by a volatility risk score that reflects real time market data. Today, in an environment where the credit spread has dipped from 8.5% down to 3.3% and there may be little additional opportunity for contraction in the high-yield fixed income space, identifying high yield, low volatility bonds is essential. DTS is the tool to do just that.

After seeing how valuable DTS can be when it comes to selecting low-volatility bonds, we took the process one step further. To gain even greater portfolio benefits, we began comparing each bond to the portfolio’s weighted average DTS and identifying each bond’s marginal contribution to risk (MCR). Looking at the S&P 500 High Yield Corporate Bond Index, this calculation is used to rank bonds from lowest to highest according to each one’s marginal contribution to risk within the portfolio. Using that ranking, it’s then simple to identify the least risky bonds; we just divide the index in half, and then select the bonds that are ranked in the lower half. Filtering for the most liquid high yield and then rebalancing no more than monthly can also help uncover that all-important sweet spot between yield, liquidity, turnover costs (which should always be considered), and risk.

Of course, by leveraging lower-risk bonds, it’s inevitable that some opportunity for higher yield will be lost. But in today’s low interest rate environment, high yield remains one of the last remaining bastions for income. In fact, high yield bonds have the highest yield per unit of risk when compared to all other income producing asset classes. For retirees and others that are generally concerned about the current level of credit spreads, this ability to lower volatility while continuing to attract high yield can help achieve one of this group’s most important goals: generating income while preserving assets. Give these clients a way to slow down and reduce risk, and you just may help them win the race.

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IndexIQ® is the indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the IQ Hedge Multi-Strategy Plus Fund. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.
Salvatore Bruno
Building Smarter Portfolios
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Sal is Chief Investment Officer at IndexIQ, where his primary responsibility includes developing and maintaining the firm’s investment strategies. Prior to joining IndexIQ, ... Click for full bio

Alternative Beta Strategies: Alpha/Beta Separation Comes to Hedge Funds

Alternative Beta Strategies: Alpha/Beta Separation Comes to Hedge Funds

Written by: Yazann Romahi, Chief Investment Officer of Quantitative Beta Strategies, J.P. Morgan Asset Management

A quiet revolution is taking place in the alternatives world. The idea of alpha/beta separation has finally made its way from traditional to alternative investing. This development brings with it a more transparent, liquid and cost-effective approach to accessing the “alternative beta” component of hedge fund return and a new means for benchmarking hedge fund managers.

The good news for investors is that the separation of hedge fund return into its components—rules-based alternative beta and active manager alpha—has the potential to shift investing as we know it. These advancements could democratize hedge funds and, at long last, make what are essentially hedge fund strategies available to all investors—even those who aren’t willing to hand over the hefty fees often associated with hedge fund investing.

A benchmark for alternatives


With respect to traditional equity investing, we have long accepted the idea that there is a market return, or beta—but this hasn’t always been the case. Investors used to assume that to make money in the stock markets, one needed to buy the right stocks and avoid the wrong ones. The idea of a market return independent of skilled stock selection seemed ridiculous to most market participants. Yet today, we would never invest in an active manager’s strategy without benchmarking it against its respective beta.

Interestingly, hedge fund managers have been held to a different standard. Investors have been much more willing to accept the notion that hedge fund strategy returns are pure alpha, and that their investment returns are based entirely on the skill of the fund manager. That notion explains why investors have been willing to accept a “two and twenty” fee structure just to access what has been perceived as one of the most sophisticated and powerful investment vehicles available.

In thinking about the concept of beta, consider its precise definition—the return achievable by taking on a systematic exposure to an economically compensated risk. In traditional long only equity investing, the traditional market beta has been further refined as a number of other risks have been identified that are commonly referred to as “strategic beta.” These include factors such as value, momentum, quality and size. But no one ever said that these risk factors must be long-only.

Over the past decade, as more hedge fund data became available, academics began to disaggregate hedge fund return into two components: compensation for a systematic exposure to a long/short type of risk (alternative beta), and an unexplained “manager alpha.” What they found is that a significant portion of hedge fund return can be attributed to alternative beta. That fact has turned the tables on how we look at hedge fund return. With the introduction of the alternative beta concept, hedge fund managers will have to state their results, not just in terms of total return, but also as excess return over an alternative beta benchmark.

Merger arbitrage—an alternative beta example


The merger arbitrage hedge fund style can be used to illustrate the alternative beta concept. In the case of merger arbitrage, the beta strategy would be the systematic process of going long every target company, while shorting its acquirer. There is an inherent return to this strategy because the target stock price typically does not immediately rise to the offer price upon the deal’s announcement. This creates an opportunity to purchase the stock at a discount prior to the deal’s completion. The premium that remains is compensation to the investor for bearing the risk that the deal may fail.

Active merger arbitrage managers can add value by choosing to invest in some deals while avoiding others. Therefore, their benchmark should be the “enter every deal” strategy, not cash. In fact, the beta strategy explains the majority of the return to the average merger arbitrage hedge fund. And it doesn’t stop there. Other hedge fund styles that can be explained using alternative beta include equity long/short, global macro, and event driven. Note that the beta strategy invests in the same securities, using the same long/short techniques as the hedge fund strategy. The difference is that the beta strategy is a rules-based version that can become the benchmark for the hedge fund strategy. After all, if a hedge fund strategy cannot beat its respective rules-based benchmark (net of fees), an investor may be wiser to stick to the beta strategy.

Implications for investors


What does all this mean for the end investor? Hedge funds have traditionally been the domain of sophisticated investors willing to pay high fees and sacrifice liquidity. Alpha/beta separation in the hedge fund world means that investors can finally choose whether to buy the active version of the hedge fund strategy or opt for the passive (beta) version. Hedge fund strategies can be effective portfolio diversifiers. Now, through alternative beta, virtually all investors can access what are essentially hedge fund strategies in a low cost, liquid, and fully transparent form. For investors who haven’t had prior access to hedge funds, this could be welcome news. Not only can investors look at an active hedge fund manager’s strategy and determine how it has done compared to the systematic beta equivalent, they can also invest in ETFs that encapsulate these systematic strategies.

When looking at one’s traditional balanced portfolio today, there are plenty of questions around whether the fixed income portion will achieve the same level of diversification it has provided in the past. After all, with yields still low, there is little income return. Additionally, the capital gains that came from interest rate declines are likely to reverse. With fixed income unlikely to adequately fulfill its traditional role in portfolios, there is a need to find an alternative source of diversification. This is where alternative strategies may help. For investors seeking to access diversifying strategies in liquid and low-cost vehicles, alternative beta strategies in ETF form are one option.

Looking for an alternative to enhance diversification in your portfolio?


For investors looking to further diversify their overall portfolio, JPMorgan Diversified Alternatives ETF (JPHF) seeks to increase diversification and reduce overall portfolio volatility through direct, diversified exposure to hedge fund strategies using a bottom-up, rules-based approach.

Learn more about JPHF and J.P. Morgan’s suite of ETFs here

DISCLOSURE

Call 1-844-4JPM-ETF or visit www.jpmorganetfs.com to obtain a prospectus. Carefully consider the investment objectives and risks as well as charges and expenses of the ETF before investing. The summary and full prospectuses contain this and other information about the ETF. Read them carefully before investing.
J.P. Morgan Asset Management
Empowering Better Decisions
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