[The following "ETF Industry Perspective" is sponsored by IndexIQ]
As Isaac Newton noted, objects in motion tend to remain in motion until something comes along to disrupt them.
This same principle has long been recognized by stock investors as a valuable tool. The strategy, known as momentum investing, seeks to overweight securities that have done well in the recent past and underweight those that have done poorly on the presumption that these trends have persistence in the market. There's substantial evidence on the stock side that this is the case. In one study,¹ the researchers found that, for many equity managers, so-called smart-beta factors—including momentum—accounted for more than 40% of the active risk taken.
If it works with stocks, what about bonds? Would an investor with an allocation across a broad range of fixed-income categories including government bonds, mortgage-backed securities (MBS) and corporate bonds benefit from a momentum strategy? Studies² using historical simulation to compare a momentum-driven approach with a classic long-only approach suggest that it is possible to enhance returns over time using momentum, without exposing the portfolio to increased downside risk.
As with equities, the strategy seeks to leverage a number of well-established principles about markets as well as human behavior. This includes the impact of fund flows and the recent negative correlation between stocks and bonds that has investors de-risking their portfolios by moving into fixed income.
In today's low-interest world, income-oriented investors need every advantage they can get. And of course, the prospect of more Fed tightening hangs over the bond market as well. Importantly, the strength of fixed-income momentum does not appear to be dependent on the overall direction of either bond or equity markets, and it is not strongly correlated with the performance of equity momentum strategies either.
One way to put this strategy to work is through a rules-based approach designed to overweight recent winners and to underweight recent losers, while not triggering excessive trading and its associated costs. ETFs provide a vehicle for putting this into practice in an efficient, low-cost manner. The two ETFs recently introduced by IndexIQ are the first real-world implementations of a rules-based momentum strategy in the bond world.
No strategy is without some risk, and that holds for momentum-based investing as well. By design, it tends to overweight securities that are in favor and underweight the securities out of favor. When there are sudden shifts in sentiment or market liquidity, momentum portfolios may underperform. But all investing involves a balance between risk and reward. In this case, momentum could be viewed as a risk factor added to a diversified portfolio of bonds—the return premium it seeks to deliver over the longer run is the compensation for that risk.
1Kahn and Lemmon (2016) studied fund manager correlations to six "smart-beta" factors for equities (market, size, value, quality, low volatility and momentum) using Barra's risk model.
2Durham, J.B., 2015. "Can Long-Only Investors Use Momentum to Beat the US Treasury Market?", Financial Analysts Journal, vol. 71, no. 5