FolioBeyond Fixed Income Commentary For July 2020
Performance Summary
FolioBeyond’s algorithm underlying the S-Network FolioBeyond Optimized Fixed Income Index (“SNFBFI”) returned +1.35% (net of a 30bp annual fee assumption) in July versus +1.49% for the Bloomberg Barclays U.S. Aggregate Bond Index (“AGG”). SNFBFI’s returns in July were primarily driven by short duration High Yield Corporate bond exposure, followed by Government Agency and long duration Treasury bond exposure. In contrast, AGG’s returns came primarily from Investment Grade Corporate bonds, MBS, and Treasuries across the yield curve. The Morningstar Multisector category performance can likely be attributed to High Yield and High-Grade credit exposure. As we discuss below, understanding return attribution, as well as major risk components, is important in effectively managing portfolios under dynamically changing environments.
Source: Morningstar
* SNFBFI’s returns are net of underlying ETF fees and 30 bp assumed management fee. Although the information herein is believed to be reliable, FolioBeyond makes no representation or warranty as to its accuracy, and information and opinions reflected herein are subject to change at any time without notice. The past performance information presented herein is not a guarantee of future results.
** The Rank is calculated using the total return of the S-Network FolioBeyond Optimized Fixed Income Index ("SNFBFI") ranked against the closing total returns of the open-end mutual funds in Morningstar's US Fund Multisector Bond Category. Percentile Rank is the total-return percentile rank of SBFBFI relative to all funds in the defined Morningstar Category. The highest (or most favorable) percentile rank is 1 and the lowest (or least favorable) percentile rank is 100.
Highlight: Sharpe Ratio and Correlation Benefits
Investors often focus on top-line return numbers and pay less attention to return attribution, portfolio risk dimensions, and correlation effects. Return attribution is important in understanding not only sources of past returns but also for anticipating risk/ return dynamics under various scenarios. AGG has benefitted greatly this year from its static duration exposure and Investment Grade Corporate and Agency MBS exposures. While these attributes have benefitted from the tailwinds of Fed support and the flight to the quality-driven bond market rally, these characteristics are less likely to be large contributors of return going forward, especially given the current absolute low levels of interest rates and narrow credit spreads. If interest rates were to rise modestly, even by 50 basis points, the value for an index like the AGG is highly exposed and will decline by roughly 3.3%, all else being equal. We can argue that in that type of scenario, our algorithmic multi-factor portfolio optimization process will maintain a lower duration profile while maintaining exposure to cheaper credit sectors.
Secondly, return volatility can often be overlooked as long as ex-post returns appear attractive. A comparison of the 1-year returns above for SNFBFI and the Morningstar Multisector category average shows the significant differences in risk relative to actual returns. While the 1-year return numbers are comparable, the Morningstar Multisector category average exhibits two times the risk of SNFBFI, as measured by its Sharpe ratio (which measures return per unit of risk). SNFBFI has had a far superior Sharpe ratio in comparison to the Morningstar Multisector Category average during this time period.
The third category of risk analysis that is often unaccounted for relates to correlation effects. It is important for portfolio allocations to benefit from correlation and diversification effects and thereby improve aggregated risk-adjusted returns. Diversification makes it possible for investors to benefit from an aggregate portfolio that is better, i.e. less risky, than the sum of the parts. If an RIA combines funds or ETFs where the underlying strategies are similar, e.g. two or three different indices that underlie funds like AGG and the Vanguard Total Bond Market Index Fund (“BND”), the correlation numbers are likely to be high and therefore have minimal portfolio benefits. The table below shows correlations among SNFBFI, the indices for AGG and BND, and the Morningstar Core Plus and Multisector category averages. The lower correlations for SNFBFI are not surprising given the algorithmic optimization process of SNFBFI in comparison to the more static exposures of AGG or BND and the general consistently high credit exposures of less dynamic Multisector funds.
Source: Morningstar
In conclusion, investors should consistently attempt to be near the efficient frontier of the investment risk /return universe. Risk should not be considered as an after-thought or a secondary metric of portfolio performance - it should be an integral part of the portfolio construction process. Sharpe ratios and correlation relationships are important measures to consider in a properly constructed portfolio. Historical returns are helpful in comparing performance on a risk-adjusted basis, but they represent performance for a particular scenario that was realized, out of a multitude of possible scenarios. As investment managers, our job is to properly manage exposures for a variety of possible future scenarios so as to effectively target higher Sharpe ratio outcomes.
Please contact us to explore our low-cost, efficiently executed multi-factor strategies. FolioBeyond can construct portfolios with unique risk/return profiles, utilizing our core tactical rules-based approach which ultimately play a valuable diversification role as we potentially exit this ultra-low interest rate environment.
