THE JOURNAL OF

SUMMER 2015 VOLUME 6 NUMBER 1 | www.IIJII.com ETFs, ETPs & Indexing

The Voices of Influence | iijournals.com

A Factor Approach to Smart Beta

Development in Fixed Income
ARNE STAAL, MARCO CORSI, SARA SHORES, AND CHRIS WOIDA

A RNE STAAL
is a managing director at
BlackRock in London,
U.K.
arne.staal@blackrock.com
M ARCO CORSI
is a director at BlackRock
in London, U.K.
marco.corsi@blackrock.com
SARA SHORES
is a managing director
at BlackRock in San
Francisco, CA.
sara.shores@blackrock.com
CHRIS WOIDA
is a director at BlackRock
in San Francisco, CA.
chris.woida@blackrock.com
A FACTOR A PPROACH TO SMART BETA DEVELOPMENT IN FIXED INCOME
A Factor Approach to Smart Beta
Development in Fixed Income
ARNE STAAL, MARCO CORSI, SARA SHORES, AND CHRIS WOIDA
A
s a bull market in bonds that lasted
for more than three decades comes
to an end, investors increasingly
question the traditional means of
accessing fixed income markets. Benchmark
indexing has guided investments ever since
the creation of the first bond indices in 1926
by Standard and Poors. Existing benchmark
indices are not without their faults however,
as they may be impacted by diversification,
liquidity, and transparency issues. These
shortcomings have been of little concern
while bond markets continued to deliver
high risk-adjusted returns in an environment
of steadily falling interest rates. In the last few
years however, the prospect of rising rates in
a low yield environment has sparked interest
in new approaches to bond investing. At the
same time, the notion of passively managed
portfolios that move away from cap weight-
ingoften called smart betahas gained
a strong foothold among equity investors.
In the pages that follow, we examine how
best to extend this way of thinking to fixed
income.
INEFFICIENCIES IN FIXED
INCOME INDICES
Since market value of debt is determined
by both bond prices and notional amount
outstanding, a cap-weighted index empha-
sizes positions in highly indebted issuers and
potentially overvalued bonds, an investment
approach that is in some ways counterintui-
tive and counterproductive. Debt issuance in
such indices is highly concentrated in a rela-
tively small number of market participants.
Exhibits 1 and 2 below illustrate the lack of
diversification in bond indices using the Bar-
clays Global Treasury Index as an example.
As of April 2015, treasury bonds from the
United States and Japan together comprise
55% of the market value of an index that
represents the sovereign debt of 38 countries.
Even more strikingly, those same two coun-
tries represent almost two-thirds of the total
risk in the index.
A very similar observation can be made
for corporate credit indices. Exhibit 3 shows
that 10% of the issuers in the Barclays U.S.
Corporate Index represent more than 55%
of both the market value and the total risk
of the index.
Market-cap-weighted equity indices
suffer from similar concentration issues, but
arguably the implications for fixed income
indices go beyond limited diversification.
While market value of any instrument
ref lects the discounted sum of expected
cash f lows, and therefore is in essence for-
ward looking, notional amount of debt out-
standing is entirely backward looking in
nature. Unlike equity indices, fixed income
index composition often ref lects historical
issuance dynamics to a larger degree than
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EXHIBIT 1 EXHIBIT 2
Barclays Global Treasury Index Country Weights Barclays Global Treasury Index Country Risk
Contribution

Source: Barclays as of April 2015.

Source: Barclays as of April 2015. The index risk is represented by its
ex-ante monthly volatility as of that date.

EXHIBIT 3
Barclays U.S. Corporate Index Issuer Weights and Risk Contribution

Source: Barclays as of April 2015The issuers represented in the Barclays U.S. Corporate Index (about 2100 issuers) are partitioned into deciles based on
weight and risk contribution. For each decile, the charts display its cumulative weight (left chart) and risk contribution (right chart). Notice that the partition
into deciles is done by ranking the issuers according to their weight (left chart) or risk contribution (right chart); the list created in this way is then partitioned
into 10 consecutive groups (each one a decile) containing an equal number of issuers.

differences in forward looking valuations. While the
primary users of benchmark indices, bond investors, aim
to achieve high returns, issuer dynamics are based on a
desire to minimize cost of capital by bond issuers. The
result is that the high weights of dominant issuers can go
hand in hand with relatively unattractive characteristics
such as relatively low fundamental quality and yields. To
illustrate, Exhibit 4 highlights the lack of relationship
between benchmark weight and yield to maturity.
Other problems stem from the market structure
in fixed income. Benchmark indices aim to represent
returns on markets for the average investor; in the end,
the sum total of outstanding instruments has to add up
to the sum total of investor positions. Unfortunately,
unlike most equity benchmarks, broad fixed income
indices are not directly investable because of liquidity
challenges and limited price transparency. Many instru-
ments contained in such indices are held in buy-to-hold

SUMMER 2015 THE JOURNAL OF INDEX INVESTING

EXHIBIT 4
Weights vs. Yields in the Barclays Global Treasury Index
Source: Barclays as of April 2015The chart displays the cumulative weight and yield to maturity for each country included into the Barclays Global
Treasury Index.
portfolios, are traded in low volume, and most are traded
over-the-counter rather than on exchanges. This makes
traditional fixed income indices challenging to replicate
in investor portfolios and imprecise tools for the purpose
of measuring actual investment outcomes.
FROM FACTORS TO SMART BETA
The increased concern about the shortcomings of
passive fixed income strategies benchmarked to tradi-
tional indices coincides with a renewed focus across
the investment industry on understanding the drivers
of return and risk across asset classes. During the credit
crisis of 2008, many actively managed investments
experienced steep losses in line with risky asset classes,
bringing increased scrutiny to portfolio allocations.
Confronted by this lack of diversification across active
and passive investments, researchers and market partici-
pants sought to analyze active returns and understand
true drivers of performance. The results solidified the
understanding that a large part of active returns can be
explained by a set of well-established, systematic invest-
A FACTOR A PPROACH TO SMART BETA DEVELOPMENT IN FIXED INCOME
ment strategies (see Ang et al. [2009] for a study on
the performance of the Norwegian Government Pen-
sion Fund). Well-known examples include portfolio
managers exploiting FX carry (long high-yielding
currencies, short low-yielding currencies), active bond
managers extending the duration of their portfolios
beyond the benchmark (accessing the term premium
in fixed income), credit managers overweighting high
yield bonds (accessing the credit carry risk premium),
equity managers increasing the weight of value stocks
in their portfolios (earning the equity value premium),
commodity funds exploiting roll congestion strategies
(long deferred contracts, short front contracts), and
hedge funds harvesting the short volatility premium
(by selling delta-hedged options).
To illustrate the extent of these systematic expo-
sures in actively managed fixed income portfolios, we
perform a principal components analysis1 on the
excess returns of a universe of 655 active European
bond managers. The results of this analysis are shown in
Exhibit 5; the first two factors generated by the prin-
cipal component analysis explain about 75% of the
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EXHIBIT 5
Explaining the Risk of a Universe of Active European Bond Managers
Source: Lipper database as of February 2015. The principal component analysis is run over monthly returns since January 2004 to February 2015. Funds
with less than five years history have been excluded from the analysis (the universe includes EUR denominated active funds (excluding absolute returns)
classified as bond funds by Lipper).
active risk 2 of such managers, suggesting that most of
their excess returns are driven by common exposures in
their portfolios. Not surprisingly, we calculate that the
first factor is very highly correlated with longer term
interest rates, indicating yield extension of active port-
folios beyond the benchmark in an attempt to generate
additional term premium return. The second factor
appears related to the slope of the interest rate curve
while the third seems to capture spread exposure. Kahn
and Lemmon [2014] suggest similar results for actively
managed U.S. bond portfolios through direct regression
of active performance on bond and credit factors.
The interest and credit rate exposures identified
above are examples of factors; commonality in returns
across instruments with similar underlying exposures
to the forces that determine investment outcomes. Both
passive and active investments are exposed to these
forces. In many cases, factors capture risk premiums (and
therefore generate excess returns by providing expo-
sure against an identified and priced economic risk),
but they can also represent behavioral phenomena or
pricing pressures driven by market structure. In the same
manner that long-only market-capitalization-weighted
investments in risky assets capture the overall market risk
premium (or beta), these strategies capture alternative
sources of returns available in the markets. Indices that
deviate from market-capitalization weighting to explic-
itly capture exposure to one or more of these factors can
be thought of as providing access to a form of alternative,
or smart, beta.
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The concept of factor investing and smart beta
has not been widely adopted in every asset class. Equity
investors have embraced non-cap-weighted index strate-
gies and factor investing to the greatest extent. At least
since the publication of the seminal paper on common
factors in equity returns by Fama and French [1992,
1993] and Carhart [1997], equity investors have been
aware of the importance of systematic factors such as
valuation (as measured, for example, by book-to-market
ratios), quality (as measured, for example, by the stability
of earnings and dividend policies), size (as measured
by market capitalization), momentum (as measured by
relative past price performance), or risk anomalies (as
measured by the outperformance of low-risk portfolios,
compared to high-risk portfolios). While the existence
of these factors has been widely recognized for many
years (and often provide the building blocks for actively
managed strategies), only recently have investors sought
to achieve exposure to these factors through a more pas-
sive and rules-based approach.
Fixed income has always been a highly analytical
and structured asset class, but investors have not yet
widely started to investigate factor-based approaches to
bond investing with particular investment objectives. The
considerable inefficiencies in benchmark fixed income
indices and the relative lack of transparent pricing of bond
instruments suggest there is a myriad of opportunities
for better passive fixed income solutions. By identifying
the drivers of risk and return for the asset class, we can
design strategies with clear objectives to meet specific
outcomes and seek better risk-adjusted returns.
THE JOURNAL OF INDEX INVESTING
WHAT DRIVES FIXED INCOME RETURNS?
To evaluate smart beta approaches in fixed income,
it is important to have a clear understanding of what
drives fixed income returns. Investment processes in
both equity and fixed income have relied on factor rep-
resentations of risk for many decades, but only since
the credit crisis has explicit outcome-oriented factor
investing become of broad interest to institutional
investors. The underlying economic forces that result in
these factors are very different depending on the instru-
ments under consideration: equity factors are mostly
understood through deep empirical analysis of pricing
behavior in a long history of academic investigation and
fixed income factors are best understood starting from
more formal valuation approaches.
Merton [1984] showed that equity can be viewed
as a long call option on firm asset value and bonds can
be viewed as a short put option on firm asset value.
This elegant argument highlights that the essence of
fixed income investing is lending money in return for
promised cash f lows, coupons and principal; both the
potential loss and gains are limited. This is very different
from equity investing. The essence of equity investing is
a promise of unknown cash f lows with unlimited upside
potential. The main implication is that fixed income
investing in many ways is much more structured than
equity investing, it is easier to value fixed income instru-
ments relative to each other with precision because the
impact of idiosyncratic differences between firms has
relatively less impact on valuation.
EXHIBIT 6
Distribution of the Relative Idiosyncratic Risk for U.S. Equities and IG Corporate Bonds
Source: Barclays, Bloomberg, and Blackrock as of April 2015. The chart displays the density function of the ratio idiosyncratic risk over systematic risk
across the constituents of the S&P 1500 Composite Equity Index and the Barclays U.S. Corporate Index).
A FACTOR A PPROACH TO SMART BETA DEVELOPMENT IN FIXED INCOME
To illustrate this insight, we decompose the risk
of individual constituents of two indices representative
of the U.S. equity and IG corporate debt market: the
S&P Composite 1500 Index and the Barclays U.S.-only
Corporate Index. For each constituent (bond or stock),
we calculate the ratio of idiosyncratic (i.e., company
specific) risk relative to systematic (i.e., factor driven)
risk. Exhibit 6 depicts the distribution of this ratio across
index constituents and shows that it is less disperse and
more concentrated around lower levels for bonds than
for equities. The average idiosyncratic risk for equities as
a percentage of systematic risk is about two times larger
than for corporate bonds, or in other words, a much
larger percentage of bond risk is explained by factors.
The two main questions in fixed income valua-
tion are:
1. What are the expected bond cash f lows and how
do markets value future payments in the absence
of default risk?
2. What is the risk that one or more of the expected
bond cash f lows will not materialize and how
should I be compensated for taking that risk?
The answers to these questions determine the two
main types of factors in fixed income markets: duration
risk (the yields represented by a treasury term struc-
ture) and credit spreads (the additional yield required to
hold a risky bond rather than a government guaranteed
bond). Depending on the complexity of the instrument,
convexity and optionality might be further systematic
SUMMER 2015
pricing factors, but they tend to be of lesser importance
in broad portfolios. Market structure phenomena such
as IG versus HY segmentation underpin other system-
atic factors such as the fallen angels effect, but while
interesting as isolated strategies, they tend to be of lesser
importance in high-capacity multi-factor approaches.
Exhibit 7 illustrates factor decomposition of f ixed
income returns.
Both academic research and industry practitioners
often view rates term structures as being driven by three
main risk factors: level, slope, and curvature. Together
these factors explain most of the return and risk of
risk-free bonds with different maturities. They can be
EXHIBIT 7
Mapping Fixed Income Factors
Source: Blackrock. (1) FX means Exchange RatesFor illustrative purposes only.
EXHIBIT 8
Explaining the Returns of the Barclays U.S. Treasury Index
Source: Barclays as of April 2015. The chart shows the R-square of a rolling linear regression of the Barclays U.S. Treasury Index monthly returns vs. the
changes in the one-year rate (24-month window).
SUMMER 2015
defined through statistical analysis or more directly as a
combination of key rates (e.g., ten minus two year rates
to represent the slope). Sometimes it is useful to further
decompose these nominal factors into real rate and inf la-
tion components (effectively doubling the number of
factors under consideration).
Exhibit 8 shows the R-square of rolling linear
regression of the Barclays U.S. Treasury Index versus
the changes in the 10-year rate; the chart suggests that
about 90% of the index returns are explained by the
10-year rate movements.
While duration factors are well understood and
visible in any market that has a liquid risk-free term
THE JOURNAL OF INDEX INVESTING
structure available, credit factors are not so well defined
or understood.
For corporate bonds, credit spreads ref lect the risk
premium the market demands for bearing default (and
to a lesser extent recovery) risk of the firm as well as
factors related to liquidity, tax and other market fric-
tions (see Collin-Dufresne et al. [2001] for a study of the
drivers of credit spreads). This gives us a starting point
for understanding the types of factors that are potentially
captured in credit spreads: bond characteristics, funda-
mental information, and technical signals could all play
a role in defining corporate credit factors. Fixed income
practitioners most often view credit factors as defined
based on sectors and ratings (i.e., high yield financials,
investment grade utilities) rather than the more quan-
titative fundamental and technical approaches taken in
equities. To what extent the quantitative approach to
(style) factor construction applies in credit is an open
question and an active area of research in both academia
and industry.
Independent of how to define corporate credit
factors, historically their application in the context of
long-only (or unleveraged) investing is hindered by
the relatively low excess returns generated by taking
on credit spread risk relative to duration risk, and the
relatively small performance differences between cor-
porate bonds in low spread environments. Exhibit 9
displays the evolution of the cross-sectional dispersion
of both corporate bond returns (in excess over duration-
matched treasury bonds) and equity returns. Cleary
EXHIBIT 9
Sector Return Dispersion in U.S. Equities and IG Corporate Bonds
Source: Barclays and Bloomberg. The chart displays the cross sectional standard deviation of monthly returns across the 24 GICS Industry Groups3 of the
S&P 500 Index and the 18 Industry Groups4 of the Barclays U.S. Corporate Index. The two classification levels have been chosen in order to have a com-
parable numbers of sectors for the two indices.
A FACTOR A PPROACH TO SMART BETA DEVELOPMENT IN FIXED INCOME
there is much less variation in performance between
the bonds than the equities. The potential for creating
diversified returns through systematic bond selection
relative to benchmark positions without application of
leverage or long-short approaches is markedly less than
in equities, apart from short periods of market turbu-
lence during which spreads and returns across bonds
diverge to a greater extent.
Which factors matter most for bonds? The rela-
tive importance of duration factors versus spread fac-
tors depends on the relative size in potential changes
in interest rates versus potential changes in spreads for
different types of bonds. For indices with low credit
spreads (investment grade bonds) duration factors domi-
nate, for high yield bonds credit spreads become more
relevant. To provide some intuition, we determine how
much of the return on a broad corporate bond index
can be attributed to risk-free term structure factors and
how much can be attributed to credit spread factors.
Exhibit 10 shows the risk and return decomposition for
the Barclays Euro Aggregate Index (results for the U.S.
or Global versions are similar).
Not surprisingly, risk is primarily driven by dura-
tion factors in broad bond indices. In some periods,
excess credit returns even contribute negatively to
total index risk as the negative correlation with rates
changes provides a degree of hedging. From a return
perspective, fixed income investors that benchmark
to market-cap-weighted indices rely on interest
rates as the primary driver of both risk and return
SUMMER 2015
EXHIBIT 10
Euro Aggregate Index Rolling Risk and Return Contribution
Source: Barclays and Blackrock. Charts based on the monthly returns of the Euro Aggregate Index from Oct 2001 to Jan 2015. Risk is measured by
rolling 24-month realized volatility. Return is measured by the 12-month cumulative return.
in their portfolio. Credit spreads have added little on
average, but do show cyclicality based on the market
environment.
DESIGNING FIXED INCOME SMART BETA
An understanding of the factors that drive fixed
income returns provides the building blocks for sys-
tematically considering smart beta approaches in fixed
income. So far, alternatives to market cap indices have
mostly been proposed on an ad hoc basis. For example,
GDP-weighted or fiscal-strength-weighted treasury
indices aim to provide alternative approaches that break
the link between issuance, price, and investment expo-
sure. Both approaches capture some notion of the issuers
ability to pay its debt but neither represent a clear invest-
ment objective. Alternative approaches in corporate
credit are often addressed from a quality perspective
based on fundamental screening, but do not typically
encompass a multi-factor approach, nor balance credit
factors relative to rates and other factors.
We believe that smart beta in fixed income indices
should provide investable solutions that aim to deliver
on clear objectives. We consider three categories for
potential objectives:
1. Better diversification.
2. Improved risk versus return profiles.
3. Precision exposure to isolated fixed income
factors.
SUMMER 2015
In the first case, we choose exposure to fixed income
factors based on a diversification scheme that intends to
balance risk impact from different exposures. Indirectly
this can lead to improved risk-return profiles over time
but the primary objective is to make sure the index is
not mainly exposed to a very limited number of return
drivers. In the second case, we aim to embed perfor-
mance related investment objectives in the index, related
for example to valuation measures. In the third case, we
isolate fixed income factors to provide building blocks to
be used in portfolio construction. We give examples of
possible smart beta approaches in all three categories.
Example 1: Macro Factor Diversification
in Aggregate Indices
We are at an inf lection point in fixed income mar-
kets in which the potential for rising rates in the U.S. and
strong global demand for safe assets can potentially
lead to scenarios in which duration can no longer be
relied upon as a sole return driver.
Historically, credit spreads have contributed rela-
tively little to the total returns and risk of benchmark
indices, but they have often provided offsetting returns
to duration driven performance. This suggests there are
untapped diversification benefits in both risk (which
could be lowered through appropriately scaled offsetting
positions) and returns (which could be higher on average
as different macroeconomic exposures will deliver at dif-
ferent points in the business cycle). We investigate if we
THE JOURNAL OF INDEX INVESTING
can meaningfully improve the robustness of passive fixed
income strategiesand reduce exposure to potentially
rising interest ratesby seeking more equal allocations
to the two main factor dimensions in bond indices.
A straightforward way of doing so would be to seek
to balance credit and interest rate exposure in a core bond
portfolio based on their relative risk contributions.
To illustrate, we rebalance the components of
the Barclays U.S. Aggregate Index in order to target
an equal risk contribution from rates and credit spread.
The strategy is constructed as a basket of U.S. Corpo-
rate Bonds (IG and HY), MBS, Treasury and Trea-
sury Futures, where the weights are determined on a
monthly basis to balance spread risk and duration risk.
EXHIBIT 11
Historical Allocation of the Risk-Balanced Strategy
Source: Barclays and Blackrock as of March 2015.
EXHIBIT 12
Risk and Return Breakdown
Source: Barclays and Blackrock. Charts based on the monthly returns of the Barclays U.S. Aggregate Index and the risk-balanced strategy from
Jan 2010 to Mar 2015. Left chart: the risk is measured by 24-month realized volatility (annualised) averaged over the last five years.
A FACTOR A PPROACH TO SMART BETA DEVELOPMENT IN FIXED INCOME
To test the effectiveness of this approach we decompose
the risk and the return of the strategy over the last five
years by identifying the contribution coming from the
rates exposure and the contribution coming from the
credit spread exposure. The results are summarized in
Exhibit 12 and highlight that the risk-balanced strategy
has a better diversified profile in terms of risk and return
contribution than the Barclays U.S. Aggregate Index.
Exhibit 13 compares the performance of the risk-bal-
anced strategy to the Barclays U.S. Aggregate Index: the
risk-balanced strategy exhibits returns very close to the
U.S. Aggregate Index but with a lower volatility, higher
yield, and balanced contributions to both risk and return
from credit and duration factors. Exhibit 11 depicts the
SUMMER 2015
historical allocation of the risk-balanced strategy across
the different buckets
Example 2: Yield-to-Quality Weighting
in Global Treasury Indices
As discussed, the current allocation of the Barclays
Global Treasury Index appears concentrated in countries
with relatively high debt burdens, which is sometimes
combined with unattractive yields (e.g., Japan). A more
EXHIBIT 13
Performance Comparison
Source: Blackrock and Barclays. Figures calculated over the period from
Dec 1991 to Mar 2015. Returns and volatility are annualisedYield to
maturity is as of March-2015Index performance is shown for illustra-
tive purposes only. One cannot invest directly in an index.
EXHIBIT 14
Comparison Between Standard and Tilted Weights
Source: Barclays and Blackrock as of January 2015.
EXHIBIT 15
Performance Comparison Between Standard Weights and Tilted Weights
Source: Blackrock and Barclays. All figures are based on monthly returns since June 2011 to January 2015. Returns and volatility are annualised. Yield
and Duration are as of January 2015. Index performance is shown for illustrative purposes only. One cannot invest directly in an index.
SUMMER 2015
attractive index could be constructed by tilting the stan-
dard weights towards those countries exhibiting a more
favorable risk-return profile. In essence, we are choosing
our exposures to different country duration and spread
factors to improve the yield-to-risk ratio of the overall
index. Various indicators have been developed to con-
struct a forward looking estimate for the credit risk of
a country; in our example we use the Blackrock Sover-
eign Risk Index (see Introducing the BlackRock Sov-
ereign Risk IndexBlackRock Investment Institute
June 2011), which has been published since 2011 and is
based on a comprehensive list of relevant fiscal, financial,
and institutional metrics. By combining the sovereign
risk indicator with the country yield, we can rank the
various countries based on their yield-to-risk tradeoff
and then we tilt weights in the standard index towards
the countries with better scores.
Exhibits 15 and 16 show that as a result of this
simple modification, the new portfolio exhibits better
risk-adjusted return, yield, and drawdown than the stan-
dard Barclays Global Treasury Index. The duration levels
are comparable.
THE JOURNAL OF INDEX INVESTING
EXHIBIT 16
Cumulative Performance and Rolling Yield
Source: Barclays and Blackrock. Charts based on monthly returns from June 2011 to January 2015.
Exhibit 14 shows a selection of the current country
weights generated by the standard market capitalization
weighting scheme and by applying our tilting rule. The
main effect of the tilting is a shift of weight from Japan,
Italy, and France towards the U.S., Germany, and South
Korea.
Example 3: Fallen Angels Provide Smart
HY Exposure
Fallen angels are high yield bonds rated as invest-
ment grade at the time of issuance that were subsequently
downgraded. The downgrade event triggers the exclu-
sion of these bonds from the main corporate indices and
a subsequent sell off driven by benchmarked investors
(trying to reduce tracking error or not allowed to hold
securities below the investment grade). The result of this
activity is pressure on the bonds price with associated
underperformance of the fallen angels with respect to
high yield bonds showing similar characteristics. Once
the selling pressure instigated by the rating migration is
over, the price tends to revert to the equilibrium level.
This phenomenon has been extensively analyzed in
academic and practitioner literature (see Ben Dor, Xu
[2010] or Ellul et al. [2010] for more details) and pro-
vides an interesting opportunity to generate returns in
excess of a standard high yield benchmark by buying
fallen angels bonds after the downgrade and holding
them over a long enough period to capture the reversal
trend. By doing so we refine our exposure to HY credit
spread factors.
A FACTOR A PPROACH TO SMART BETA DEVELOPMENT IN FIXED INCOME
To illustrate, we test the performance of a strategy
that invests in all the bonds included in the Barclays U.S.
High Yield Index that were rated as investment grade at
the time of their issuance. The bonds are market-cap-
weighted and the basket is rebalanced on a monthly
basis.
Exhibits 17 and 18 compare the performance of the
newly created strategy with the performance of the Bar-
clays U.S. High Yield Index (used here as a benchmark).
The fallen angels strategy outperforms the benchmark
in terms of (risk-adjusted) returns with a slightly higher
level of volatility and drawdown. The duration of the
strategy is historically higher than for the benchmark and
the yield to maturity is comparable (see Exhibit 19), but
the outperformance is mainly driven by mean-reverting
credit spreads of fallen angels, not different exposure to
rates factors.
CONCLUSION
The risk and return of broad fixed income indices
are driven predominately by interest rate (or risk free
duration) factors. While historically investors have been
well compensated for outsized exposures to interest rate
risk, with interest rates near lower bounds across the
developed world, the outlook for continued rewards from
market-cap-benchmarked fixed income investing now
looks less appealing. Rate dominated portfolios provide
diversification versus equities and other risky asset classes
in multi-asset portfolios, and will retain their value as
a hedge in f light-to-quality environments. However,
SUMMER 2015
EXHIBIT 17
Cumulative Performance of the Fallen Angels Strategy

Source: Barclays as of April 2015. Chart based on monthly returns from August 1998 to March 2015.

EXHIBIT 18
Performance of the Fallen Angels Strategy vs. the Barclays U.S. HY Index

Source: Barclays as of April 2015. All figures are based on monthly returns since August 1998 to March 2015. Returns and volatility are annualised.
Yield and Duration are as of March 2015. Index performance is shown for illustrative purposes only. One cannot invest directly in an index.

EXHIBIT 19
Rolling Duration and Yield

Source: Barclays as of April 2015. Charts based on monthly data since August 1998 to March 2015.

we question the ability of conventional fixed income
strategies to generate attractive long-term returns in the
current macroeconomic environment on a stand-alone
basis. Innovation in core fixed income investing may
therefore be necessary to navigate increased uncertainty
in the macroeconomic landscape. Smart beta fixed
income approaches bring this innovation. They aim to
better position passively oriented portfolios for an uncer-
tain future. They seek to provide improved risk-adjusted
returns by building portfolios to deliberately capture and
diversify the sources of risk and return in fixed income.
Time will tell if these promises will be fulfilled, but the
opportunities are surely worth pursuing.

SUMMER 2015 THE JOURNAL OF INDEX INVESTING

ENDNOTES
The opinions expressed are as of April 14, 2015 and are
subject to change at any time due to changes in market or
economic conditions.
1
Principal component analysis is a well-established sta-
tistical technique developed by Pearson [1901]. The analysis
aims at simplifying a data set by identifying latent common
factors driving the risk of a pre-defined universe. With
respect to our problem this technique can be used to iden-
tify the factors driving the risk of the considered universe of
European active managers. For a reference explaining the
principal component analysis please see:
a. Hotelling, Harold, 1933. Analysis of a Complex of
Statistical Variables into Principal Components. Journal of
Educational Psychology, 24(6 & 7), 417441 & 498520.
b. Jolliffe, I. T., 2002. Principal Component Analysis.
Second ed. Springer Series in Statistics. New York: Springer-
Verlag New York.
c. Pearson, Karl, 1901. On Lines and Planes of Closest
Fit to Systems of Points in Space. Philosophical Magazine,
Series 6, 2(11), 559572.
2
As measured by the realized variance.
3
The 24 GICS Industry groups are: Energy, Materials,
Capital Goods, Commercial and Professional Services, Trans-
portation, Automobiles and Comp., Consumer Durables
and App., Consumer Services, Media, Retailing, Food and
Staples Retailing, Food, Beverage and Tobacco, Households
and personal products, Health Care Equipment and Ser-
vices, Pharma, Biotech and Life Science, Banks, Diversified
Financials, Insurance, Real Estate, Software and Services,
Technology Hardware and Equipment, Semiconductors and
Semiconductors Equip., Telecom. Services, and Utilities.
4
The 18 Industry Groups used in the Barclays Index are:
Banking, Brokerage Asset Managers Exchanges, Finance Com-
panies, Insurance, REITS, Other Financial, Basic Industry,
Capital Goods, Consumer Cyclical, Consumer Non-Cyclical,
Energy, Technology, Transportation, Communications, Indus-
trial Other, Electric, Natural Gas, and Other Utility.
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Ben Dor, A., J. Xu, and A. Fallen. Characteristics, Perfor-
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Fama, E.F., and French, K.R. The Cross-Section of Expected
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To order reprints of this article, please contact Dewey Palmieri
at dpalmieri@ iijournals.com or 212-224-3675.
Disclaimer
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Summer 2015