If you’re anything like me, you cherish ‘aha’ moments , especially when that ‘aha’ is the realization that something you’ve been using for just one purpose can do so much more.
And whether the insight comes from your colleagues, kids, or friends, the new use can seem so obvious that you have to wonder: “Why didn’t I think of that before?” Of course, while learning how to use binder clips to keep all those computer cables in place is great, when the hack applies to investing, the impact can be much greater—potentially changing how you think, how you invest, and even your long-term financial outlook. Even better: when that realization comes just when you need it most.
Volatility seems to be the number-one topic on investors’ minds as the market continues to react—positively and negatively—to the US political climate, the slow but steady end to a sustained low-interest rate period, and record-breaking hikes in the equities markets. The situation has many advisors focusing more than ever on the delicate balance between risk and opportunity to help sustain long-term returns for their clients. And as you build out your strategy moving forward, one question rises to the top: How can I maintain an appropriate level of fixed income within my portfolio—without suffering the downside of rising interest rates on those assets? The answer may be something you least expect: Momentum.
Using the power of momentum in the equities and commodities space is nothing new. Momentum and relative strength are used by many advisors and fund managers to effectively overweight securities that are trending upward, and underweight securities that are trending downward. But while academic research has demonstrated that the same technique can be applied to the fixed-income space, theory has rarely been put into practice[if !supportFootnotes][endif]. But as rising interest rates have created a looming challenge, the time for applying a momentum strategy to fixed income in the real world has finally come. In fact, all of us may be a bit late on the uptake. Fixed income momentum may be a strategy well worth considering as a smart alternative to the Barclays Agg Index.
Intrigued? Here’s how it works:
In the same way momentum has been applied to the equities market for decades, momentum-style investing can be applied to fixed income by dynamically reallocating sectors monthly using the major sector building blocks of the Barclays Agg Index. The goal: to outperform the Index, but always within a specified risk tolerance level. As with any momentum approach, fake signals that can arise from erratic short-term moves can present issues, and comparing different sectors on the same basis can be another major challenge. Both concerns can be addressed using a volatility-adjusted crossover signal for the momentum score calculation. It’s simpler than it sounds. By comparing a short-horizon (45 days) moving average of the total return index to a longer-horizon (90 days) moving average of the total return index, fake signals can be identified and canceled out. And by using sector weight and tracking error constraints, it’s much easier to manage risk across the portfolio to increase the potential opportunity of outperforming the benchmark.
Of course, few advisors have the time to perform such a detailed momentum-based strategy, especially monthly, which is why using an ETF to apply the approach as part of a core portfolio is so useful. ETFs have certainly been one of the biggest investing life hacks of the past decade. With fixed income becoming a bigger concern every day, now may be the perfect time to add another life hack—fixed-income momentum investing—to your advisor toolbox.
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[endif] Bruno, Salvatore. IndexIQ Research Paper. “Fixed Income Momentum Investing.” October 2016.