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STRICTLY PRIVATE AND CONFIDENTIAL ©
Characterising Investment Styles in
Fixed Income Markets
Vasant Naik
Head of FI Quantitative Strategies
May 2010
Fixed Income Quantitative Strategies
Vasant Naik [email protected]
Srivaths Balakrishnan [email protected]
Mukundan Devarajan [email protected]
Tom Andrews [email protected]
Research team
Page 2
Overview
Page 3
Top-down investment styles in Fixed Income markets
Long sample unconditional performance of investment styles
Macro properties of returns of investment styles
Comparison of Fixed Income Styles with those in Equity markets
©
Top-down investment styles in
Fixed Income Markets
Page 4
Top-down Investment Styles
Source: Nomura Research
Classification of Top-down Investment Styles in Fixed
Income Markets
Price MomentumReturn continuation
Page 5
Macro MomentumPersistence of macro regimes
Carry
Random walk in asset prices
Value
Mean reversion from extremes
in asset prices
Interest rates Corporate Credit Currencies Commodities
Fixed income asset classes
Top-down Investment Styles in Fixed Income (contd.)
Page 6
Price Momentum:
Buy assets with strong returns against those with weak returns
Macro Momentum:
Buy risky assets in periods of economic strength and less risky ones in periods of
economic weakness
Carry:
Rates: Buy bonds when yield curves are steep
Credit: Buy corporate credit when credit curves are steep
Currencies: Buy currencies with high interest rates against those with low interest rates
Commodities: Buy backwardated commodities and sell those in contango
Value:
Buy when prices are significantly below fair value and sell when they are above
The Performance of Momentum and Carry-based
Strategies is Stronger than that of Value
Source: Nomura Research
All performance numbers are for volatility-adjusted investment strategies and are before transactions costs
1. Hit ratio is defined as the proportion of months with strictly positive excess returns
Momentum Carry Value
1976-2010
Average annual excess returns (%) 3.3 1.4 0.5
Annualised information ratio 1.47 0.77 0.26
Skew 1.4 -0.4 -1.5
Hit Ratio(1) 72% 63% 57%
1990-2010
Average annual excess returns (%) 3.2 1.4 0.4
Annualised information ratio 1.40 0.73 0.18
Skew 1.5 -1.0 -2.0
Hit Ratio(1) 72% 63% 57%
Page 7
Performance of investment styles: 1976 – 2010
Correlation between Style-based Strategies is not
Markedly High...
Source: Nomura Research
Momentum and Carry Momentum and Value Carry and Value
Full Sample Correlation
(1976-2010)7% -18% 41%
Median of rolling 5-year correlations
1981-2010 3% -25% 45%
1990-2010 3% -31% 53%
1999-2010 -4% -43% 46%
2007-2010 0% -26% 3%
Page 8
Correlations between style-based strategies
...which Prompts their Application as a Portfolio of
Style-based Investments
Source: Nomura Research
All performance numbers are before transactions costs. The portfolio is constructed with the following risk weights:
Momentum 50%, Carry 25%, Value 25%
1. The actual excess returns for 2008 are 7.1%. The chart has been truncated at 6% for improved readability.
1976-2010
Avg. ex. returns (% pa) 2.1
Ann. information ratio 1.60
Skew 1.4
Hit Ratio 71%
1990-2010
Avg. ex. returns (% pa) 2.1
Ann. information ratio 1.59
Skew 1.2
Hit Ratio 70%
Page 9
-1%
0%
1%
2%
3%
4%
5%
6%
1976
1979
1982
1985
1988
1991
1994
1997
2000
2003
2006
2009
Annual performance profile(1)
Returns of Style-based Strategies Also Help Attribute
Risk Exposures of Portfolios
Source: Nomura Research, HFRI, CS Tremont, Bloomberg
***, **, * represent significance at the 97.5%, 95% and 90% levels
Momentum ( ) Carry ( ) Value ( ) R2
HFRI Fund of Funds Wtd. Composite -1.0*** 0.7*** 0.0 16%
CS Tremont Managed Futures 1.8*** 1.7*** -1.3*** 25%
HFRI Macro Systematic Diversified 0.2 0.7*** -0.5** 4%
HFRI Relative Value -0.9*** 0.3** 0.2 29%
HFRI Event Driven -1.2*** 0.6*** 0.0 19%
Page 10
Regression of Hedge Fund Index excess returns on those of style-based portfolios (1990-2010)
t
Value
tV
Carry
tC
Mmtm
tM
Portfolio
t rrrr
M C V
©
Macro properties of style-based
investment strategies
Page 11
Momentum and Carry Trades Perform well in
Economic Expansions...
Source: Nomura Research, NBER. We define early and late periods of expansions as their first and second calendar
halves.
Annualised information ratios of style-based portfolios in Expansions
1976-2010 Momentum Carry Value
Full Sample unconditional 1.47 0.77 0.26
Expansion periods 1.60 0.79 0.18
Early expansions 1.64 0.90 0.31
Late expansions 1.58 0.70 0.07
Page 12
-10
0
10
20
Dec-78 Nov-81 Nov-84 Nov-87 Nov-90 Nov-93 Nov-96 Nov-99 Nov-02 Nov-05 Nov-08
NBER Recessions Momentum Carry Value
Rolling three-year excess returns (%)
...while the Performance of Value Trades is Largely
Restricted to Periods of Economic Weakness
Source: Nomura Research, NBER We define early and late periods of recessions as their first and second calendar
halves.
Annualised information ratios of style-based portfolios in Recessions
1976-2010 Momentum Carry Value
Full Sample unconditional 1.47 0.77 0.26
Recession periods 1.36 0.65 0.68
Early recessions 2.13 1.61 0.81
Late recessions 0.40 -0.49 0.53
Page 13
-10
0
10
20
Dec-78 Nov-81 Nov-84 Nov-87 Nov-90 Nov-93 Nov-96 Nov-99 Nov-02 Nov-05 Nov-08
NBER Recessions Momentum Carry Value
Rolling three-year excess returns (%)
The Underperformance of Momentum in Late
Recessions is Broad-based...
Source: Nomura Research, NBER We define early and late periods of recessions and expansions as their first and
second calendar halves.
Annualised information ratios of Momentum portfolios by sub-style and by asset class
Momentum by Sub-style Momentum by Asset Class
1976-2010 Price Macro Interest Rates Credit Currencies Commodities
Full Sample 1.15 0.98 1.14 0.42 1.02 0.73
Expansion periods 1.25 1.05 1.22 0.36 1.12 0.67
Recession periods 1.04 1.30 1.28 0.70 0.75 1.06
Early recessions 1.68 2.28 1.82 1.52 1.26 1.80
Late recessions 0.17 0.14 0.72 -0.59 0.0 0.15
Page 14
...while that of Carry in Late Recessions is Attributable
to Asset Classes Other than Currencies
Source: Nomura Research, NBER We define early and late periods of recessions and expansions as their first and
second calendar halves.
Annualised information ratios of Carry portfolios by asset class
Carry by Asset Class
1976-2010 Interest Rates Credit Currencies Commodities
Full Sample 0.43 0.38 0.36 0.50
Expansion periods 0.59 0.36 0.43 0.40
Recession periods -0.08 0.46 0.06 1.01
Early recessions 0.10 1.92 -0.80 1.93
Late recessions -0.35 -1.31 1.63 -0.14
Page 15
Regimes of Monetary Easing are Favourable for Value
Investments
1976-2010 Momentum Carry Value
Monetary Tightening
regime
Average quarterly excess return (bp) 92 54 -2
Annualised information ratio 1.84 1.02 -0.05
Monetary Easing
regime
Average quarterly excess return (bp) 71 35 49
Annualised information ratio 1.00 0.67 1.07
Page 16
Source: Nomura Research, Bloomberg
Note: We divide the history into three equally sized buckets based on the average of normalised quarterly changes in
policy rates across the G-7 economies. We then present the average same-quarter excess returns and information
ratios of the investment strategies based on Momentum, Carry and Value styles in the top and bottom buckets.
These Macro Properties are Reflected in their
Correlation with Bond Markets...
Source: Nomura Research, Bloomberg
Correlations have been computed using quarterly excess returns. Excess returns of the US Treasury index are over
cash.
Page 17
Momentum Carry Value
Full Sample Correlation
(1976-2010)28% -26% -6%
Median of rolling 5-year correlations
1981-2010 43% -26% -6%
1990-2010 15% 46% -11%
1999-2010 51% -15% -36%
2007-2010 53% -19% -32%
Correlations between style-based portfolios and US Treasury 1-10yr Index Excess Returns
... And with Equity Markets
Source: Nomura Research, Bloomberg
Correlations have been computed using quarterly excess returns. Excess returns of the S&P 500 index are over cash.
Page 18
Momentum Carry Value
Full Sample Correlation
(1976-2010)-28% -2% 11%
Median of rolling 5-year correlations
1981-2010 -20% 6% -1%
1990-2010 15% -23% 11%
1999-2010 -43% 14% 27%
2007-2010 -43% 14% 16%
Correlations between style-based portfolios and S&P 500 Excess Returns
In Periods of Heightened Investor Risk Aversion
Momentum Outperforms while Value Underperforms
Source: Nomura Research, Bloomberg
Note: We divide the history into three equally sized buckets based on the quarterly changes in the VXO Index. We
then present the average same-quarter excess returns and information ratios of the investment strategies based on
Momentum, Carry and Value styles in the top and bottom buckets.
1986-2010 Momentum Carry Value
Low risk aversion
Average quarterly excess return (bp) 29 17 33
Annualised information ratio 0.61 0.37 0.78
High risk aversion
Average quarterly excess return (bp) 117 29 -7
Annualised information ratio 1.57 0.42 -0.08
Page 19
This Pattern in Observed in Regimes of Tightening
Credit Conditions as Well
1976-2010 Momentum Carry Value
Credit Easing
Average quarterly excess return (bp) 66 29 24
Annualised information ratio 0.93 0.56 0.54
Credit Tightening
Average quarterly excess return (bp) 129 34 3
Annualised information ratio 2.00 0.54 0.04
Page 20
Source: Nomura Research, Bloomberg
Note: We divide the history into three equally sized buckets based on the quarterly changes in the spread between 3
month Commercial Paper and 3 month treasury bills. We then present the average same-quarter excess returns and
information ratios of the investment strategies based on Momentum, Carry and Value styles in the top and bottom
buckets.
©
How do Styles in Fixed Income
Compare with those in Equity
Markets?
Page 21
The Evidence for Persistence is Stronger than
Reversion to ‘Fair’ Value in Equity Styles as well
Source: Nomura Research, Kenneth French Data Library
Data for US Equities alone. Performance shown is that of volatility-adjusted strategies before transactions costs.
Equity ‘Carry’ : Buy top 30% stocks by Dividend/Price and sell bottom 30%.
Equity ‘Value’ : Buy bottom 30% stocks by prior long term return and sell the top 30%.
Equity Momentum Equity „Carry‟ Equity „Value‟
1976-2010
Average annual excess returns (%) 15.5 0.0 3.1
Annualised information ratio 0.74 0.00 0.16
Skew -0.75 -0.01 0.20
Hit Ratio(1) 64% 50% 53%
1990-2010
Average annual excess returns (%) 14.0 -0.6 7.9
Annualised information ratio 0.62 -0.03 0.39
Skew -0.77 0.23 0.58
Hit Ratio(1) 62% 49% 56%
Page 22
Performance of Equity investment styles: 1976 – 2010
Performance of Equity Styles is not Highly Correlated
with that of Fixed Income Styles...
Source: Nomura Research, Kenneth French Data Library
Page 23
Momentum Carry Value
Full Sample Correlation
(1976-2010)14% -4% -5%
Median of 5-year rolling correlations
1981-2010 13% -2% -4%
1990-2010 16% -8% -15%
1999-2010 13% -21% -9%
2007-2010 21% -19% -5%
Correlations between style-based portfolios in Equities and Fixed Income
...but their Macro Properties are Somewhat Similar
Source: Nomura Research, NBER, Kenneth French Data Library
Note: We define early and late periods of recessions and expansions as the first and second calendar halves
respectively, of such periods
Annualised information ratios of investment styles in Equities
1976-2010 Equity Momentum Equity „Carry‟ Equity „Value‟
Recession period
Early recessions 0.77 0.93 0.70
Late recessions -0.70 -1.53 0.52
Expansion period
Early expansions 0.91 0.36 0.13
Mature expansions 1.02 -0.30 -0.05
Full Sample 0.74 0.00 0.16
Page 24
©
How have Style-based
Investments Performed Recently?
Page 25
Source: Nomura Research, Kenneth French Data Library
Equity ‘Carry’ : Buy top 30% stocks by Dividend/Price and sell bottom 30%.
Equity ‘Value’ : Buy bottom 30% stocks by prior long term return and sell the top 30%.
Page 26
(%, p.a.) Equity Momentum Equity „Carry‟ Equity „Value‟
2007 50.1 -19.8 -48.1
2008 30.5 26.2 7.4
2009 -62.3 -21.2 5.1
Average annual excess returns (%) 15.5 0.0 3.1
Annualised volatility (%) 21.1 18.8 19.8
It is Well-known that Equity Momentum Outperformed
in 2007-08 while Value did so in 2009
Recent performance of style-based investment strategies: 2007-2009
Source: Nomura Research
Page 27
(%, p.a.) Momentum Carry Value
2007 3.3 1.5 -2.8
2008 13.9 2.8 -2.2
2009 -0.7 -0.8 3.2
Average annual excess returns (%) 3.3 1.4 0.5
Annualised volatility 2.2 1.9 2.0
Fixed Income Styles Exhibited a Similar Pattern
During the Recent Crisis
Recent performance of style-based investment strategies: 2007-2009
©
Conclusions
Page 28
Conclusions
Page 29
We classify investment styles in Fixed Income markets into those based on (a)
Momentum, (b) Carry and (c) Reversion to fair value
In the long historical sample, we find that the performance of Momentum and Carry
is robust while that of Value is relatively weaker
Momentum and Carry trades perform well in Early recessions while Value does so
in Late Recessions
Similar unconditional and macro properties of investment styles are observed in
the equity markets as well
Analyst certification
We, Vasant Naik and Mukundan Devarajan, hereby certify (1) that the views expressed in this report accurately reflect my personal views about any or all of the subject securities or issuers referred
to in this research and (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views contained in this research.
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