Fixed-income investing in today’s environment is challenging, to say the least. With the Federal Reserve’s recent commitment to keeping the federal funds rate to no more than 0.25%, things aren’t looking promising for fixed-income investors. Is there any way to solve the zero interest rate problem?
The answer, according to Jeff Rosenberg, portfolio manager of the BlackRock Systematic Multi-Strategy Fund (ticker: BIMBX), is to be “systematic.”
For years, Rosenberg’s team has been using a systematic, research-driven approach to active strategies to meet risk, reward and diversification objectives.
We spoke with Rosenberg about the team’s systematic approach to fixed-income investing to learn how it’s done and how financial advisors and investors can employ it in their own portfolios.
Here are edited excerpts from that conversation.
What is systematic fixed-income investing?
Systematic investing is an investment approach that is often synonymous with quantitative investing. These strategies employ an objective, disciplined and repeatable process to identify, test and implement investment ideas. Its hallmarks are highly diversified portfolios based on a diverse set of “signals” or insights that inform the portfolio construction process.
The process uses financial engineering to help ensure the exact mix and separation of sources of returns. By “sources of return,” I mean clearly differentiating returns sourced from market direction and factor exposures – think interest rate risk or credit risk – from pure alpha returns – those that reflect purely idiosyncratic sources without reliance on market, factor or illiquidity risk.
In our approach, we believe people are best at generating and researching investment ideas and performing the critical tasks of portfolio management and trading, while technology helps remove emotion and behavioral biases from the process. The advantages to this approach lie in its ability to create highly customizable return streams to meet specific risk, reward and diversification properties.
Why does a systematic approach to fixed income make sense in today’s market environment?
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In today’s markets, both the level of yields and abundance of data available for investors to process create challenges where systematic fixed-income strategies can help.
In the current market environment, fixed income offers far lower yields and much less price appreciation. Tight levels of credit spreads and an outlook for rising interest rates lead to low, and even zero or negative, expected returns in fixed income.
We use our systematic approach to target explicit return outcomes. By separating sources of returns into directional and idiosyncratic components, we can engineer for specific outcomes from our return streams. That is increasingly important in today’s market environment, where the ability to rely heavily on simply overweighting the directional component of falling interest rates and tightening spreads to deliver added returns no longer exists. Today, pure alpha returns – returns based on the idiosyncratic risks available in the market – need to play a larger role to offset this loss of expected return, yield and the diversification properties of fixed income.
Additionally, the sheer volume of data available to investors has never been higher. The challenge is turning data into insights. For years, investors have poured over economic data, company financials and pricing data. In the last decade, the increasing use of text mining, alternative data and big data have created new tools in our toolkit. Our approach applies human expertise on top of quantitative tools to enhance risk management and risk-adjusted returns.
You manage the BlackRock Systematic Multi-Strategy Fund. How does the fund help solve today’s zero interest rate problem?
The zero interest rate problem really poses two issues for investors. First, since yield is the best long-run predictor of returns in fixed income, the low level of rates simply implies low returns. Second, zero interest rates – or more specifically, the zero lower-bound on rates – implies a limit to how much rates can fall during periods of crisis or economic downturn. Long-term interest rates stand at historically low levels as well. Typically, 10-year interest rates fall more than 300 basis points during recessions. Clearly, with 10-year rates close to 1%, they can’t fall as much. And that limits the diversification property we can expect from fixed income during the next equity market downturn.
The Systematic Multi-Strategy Fund can help solve this problem by providing a liquid alternative to fixed income. This alternative aims to preserve the expected returns of fixed income that can participate in equity market upside, while providing downside protection during equity market downturns. We do this through designing a set of complementary and diversifying strategies aimed to contribute to the attainment of those dual objectives.
To these strategies, we add two sets of diversifying, pure alpha-orientated strategies that enhance the fund’s sources of downside protection. One group of strategies, called “macro,” look to exploit cross-sectional dispersion in the global macro interest rates and yield curve space. These returns tend to be strongest during large disruptive events – think the taper tantrum, the eurozone crisis or the onset of the COVID-19 crisis in March 2020.
The second set of pure alpha-orientated strategies enhances the fund’s critical downside protection against equity market downturns. These strategies take a highly diversified approach to long/short equity investing. They build a portfolio that is neutral in direction, beta and factor exposure, but tends to deliver its strongest returns during equity market downturns. It does this through evaluating the attractiveness of a security through the lens of a credit investor.
Importantly, these aspects tend to become more important determinants of equity valuations during equity market downturns, and this results in stronger returns to the strategies during those downturns.
What is your outlook for fixed-income markets in 2021?
The baseline outlook is positive, as hopes for an emergence from the COVID-19 crisis through vaccine rollout and herd immunity, alongside historic levels of monetary and fiscal support, lead to expected surges in economic activity. The implication for fixed-income performance, however, is less positive, as the rise in interest rates under this baseline scenario likely overwhelms other sources of returns, particularly given the low starting point of yields.
The combination of higher rates and low income lead to zero, or even negative, expected returns for safe areas of fixed income. Higher risk areas such as high-yield debt or emerging market debt should fare better under the baseline scenario. But the potential for negative developments do not appear reflected in the price of these riskier assets, leaving them more vulnerable to any negative surprises.
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