This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features Rusty Vanneman, chief investment officer of Omaha, Nebraska-based CLS Investments.
Factor-based equity has become increasingly popular in recent years, and for good reason: It works over time, especially in down markets.
I wrote an article on this point last year, specifically about reinterpreting the classic “Callan chart” by showing the performance of equity factors instead of asset classes. The revised chart had two important twists.
First, it showed relative performance (versus the overall stock market) instead of absolute performance. Second, it showed the strong probability of positive relative returns over time. As a single picture, it’s extremely compelling evidence that factors worked in the stock market, at least over the last two decades.
Two Key Fixed-Income Factors
The same is true with fixed-income factors. There are two factors in the fixed-income world that have provided persistent outperformance: duration and credit.
Duration is technically defined as “interest rate sensitivity.” For the most part, it means emphasizing longer-bond maturities. Typically, a bond with a longer maturity carries more perceived risk since it takes longer for investors to get their money back; thus, it typically has a higher yield.
Credit refers to credit risk. The lower a bond’s credit quality—meaning the more likely it is to default—the higher the required yield by investors. Over time, this additional yield is usually more than enough to offset losses from defaults.
Below is a table showing the annual performance of these two fixed-income factors since 1992.
For a larger view, please click on the image above.
Returns Vs. Cash
For the duration factor, the Bloomberg Barclays 5-7 Year Index was used (an argument could be made for an even longer duration). For the credit factor, the Bank of America/Merrill Lynch High Yield Master II Index was used.
The relative returns in this case are versus cash. This is a good measuring stick, as many investors don’t use bonds and just use cash to diversify equity portfolios.