Systematic DM Fixed Income Smart Beta

Systematic Developed Market Sovereign Fixed Income
Copyright © 2019 FactSet Research Systems Inc. All rights reserved. Confidential: Do not forward.
Contents
• Overview
• Fixed income smart beta: concept and market landscape
• Smart beta indexes: our view on alternative approaches
• Objective and proposal
• Building A Smart Beta Portfolio

• FI Smart beta portfolio construction
• Building the alpha-driven portfolio
• Alpha signal examples
• Proposed model: concepts, structure, results

• What alpha model we propose
• What motivates our alpha model proposal
• Alpha model performance
• From alpha model to smart beta model
• Appendix
Copyright © 2017 FactSet Research Systems Inc. All rights reserved. Confidential: Do not forward. 2
Overview
Fixed income smart beta: concept and market landscape
– What is smart beta?
An investment portfolio that strives to generate better risk-adjusted returns over traditional market-cap-
weighted indexes by exploiting alternative asset weighting mechanisms
– Fixed income (FI) markets have been slow to evolve the smart beta segment:
• Fear of “alpha” erosion: institutional investors have little incentive to map their high-fee active long-short proprietary FI
strategies to low-fee passive long-only funds that would compete in the same investment space
• As a corollary from the above, publicly available research in FI factor investing and smart beta has not been particularly
prolific and has appeared in relatively recent years. This has hindered investors’ attempts to independently verify the
performance-enhancing potential of factors in FI smart beta applications.
• Liquidity and trading cost: unlike equities, that most often trade on centralized exchanges, FI instruments (cash bonds) trade
over the counter. This implies greater liquidity and transaction costs in executing a model-driven portfolio that endogenously
evolves and updates over time.
– Current FI ETF market landscape

• Significant focus on USD FI. Fewer products offer a truly global FI exposure.
• The vast majority of FI ETFs track and replicate the performance of “well-known” benchmark indexes
• This accounts for :
1) their market-cap-weighted structure with no attempt / need to weigh “smartly” and
2) often heterogeneous nature mixing structurally different countries, different credit ratings and maturity structures that are driven by significantly
different conceptual factors.
Smart beta indexes: our view on alternative approaches
– Traditional frameworks adopted in equity space as well as our accumulated knowledge allow us to
identify two main methodological approaches to constructing smart beta indexes that can be applied
to fixed income that offer non-market-cap asset weighting (please see the next slide for a graphical
summary)
• Strategy / diversification-based: frameworks that offer alternative asset weighting schemes through either the targeting of
a particular quantitative objective (i.e. minimum variance; maximum Sharpe ratio; equal duration contribution etc.) or through
the application of “external” weighting criteria (i.e. Gross Domestic Product-weighted; equal weights etc.)
• Factor-based: frameworks that offer alternative asset weighting schemes derived from deep conceptual understanding
regarding the main driving forces (factors) behind a universe of assets, sensible methods to quantify those factors in a
continuous and systematic way and sensible methods to capture interactions between different factors
– Currently it is on our agenda to initiate our research work by focusing on building a multi-factor
conceptual prior-based fixed income smart beta framework
– At the same time, we believe in the value of developing a well-diversified suite of fixed income smart
beta capabilities, both strategy- and factor-based. We therefore aim to concentrate our efforts on
expanding the scope of our fixed income smart beta offerings over time to cover the different
methodological possibilities described on the next slide.
Smart Beta Indexes
Non market-capitalization weighted

rule based indexes
Strategy Based
Factor Based
(Diversification Based)
Alternative Rules/Rank-based
Risk Based Optimized
Weighting (Non-optimized)
Fundamental Weighted Minimum Variance Single Factor

Value Momentum
Maximum
Equal Weighted Diversification Low Volatility Carry
Equal Risk Contribution Maximum Sharpe Ratio

Multi Factor
Value, Momentum,
Equal Duration Quality, Value
Maximum STARR Ratio Quality and Low Size
Contribution
Factor Based
Developed
Rules/Rank-based Sovereign
Optimized
(Non-optimized)
Emerging
Single Factor
Value Momentum
Developed
Low Volatility Carry
Corporate
Multi Factor
Value, Momentum,
Quality, Value Emerging
Quality and Low Size
Objective and Proposal
- Objective
Build an investable long-only fixed income smart-beta portfolio that gives investors exposure to global
sovereign debt and/or interest rate dynamics while delivering superior risk-adjusted performance to
benchmarks weighted through industry-standard ways via
• diversified multi-factor approach: we recognize that asset prices are not driven by a single factor
but by the constant interaction of conceptually different factors,
• diversified insight approach within each factor: we recognize that there is no one “right” way to
measure the behavior of a given factor and therefore we need to look at a factor from as wide a
spectrum of angles as possible
• quantitative framework that is derived from conceptual priors: we emphasize the importance of
understanding our investment space and exploiting the opportunities it offers in a disciplined and
systematic way
- Proposal
Multi-factor smart-beta portfolio in long-dated (10Y) nominal sovereign debt in developed market space
(i.e. all or a subset of EUR, SEK, NOK, CHF, GBP, USD, CAD, AUD, NZD, JPY)
Building A Smart Beta Portfolio
FI Smart Beta Portfolio Construction
We would like to think of a smart beta portfolio as a combination of two separate portfolios
– Benchmark portfolio
• Gives the starting tilts into the various assets
• “Naïve” weights across the assets (i.e. often market-cap-based but can also be equal weights etc.)
• Long-only portfolio (i.e. all weights are non-negative)
• Weights sum to one (i.e. full investment constraint)
– Alpha-driven portfolio as an overlay on top of the benchmark portfolio

• Gives a framework to overweight or underweight the different assets relative to the benchmark portfolio
• Weights are a direct function of the relative ranking of the assets along a certain prior-based “signal” dimension
– A signal is an empirical measurement of a given conceptual entity. For example, “strong growth” signal, “weak inflation” signal etc.
– i.e. the US and Canadian economies are both growing at a positive rate but the US is growing at a faster rate
• Long-short portfolio (i.e. weights / holdings can be both long and short) based on our priors on how the “signal” maps to the
assets - i.e. stronger growth is negative for nominal fixed income (this is our signal transmission prior) → USD is growing
more strongly than CAD → go long CAD and short USD government bonds
• Weights need to respect certain constraints in order to preserve the overall characteristics of the benchmark portfolio, i.e.
– Weights need to sum to zero (such that adding them to the benchmark weights preserves the full investment constraint)
– For each asset, 1 ≥ benchmark weight + alpha weight ≥ 0
Building the alpha-driven portfolio
Investment hypothesis
Raw signal data
Directional signals
Cross-sectional signals
Raw asset analytics
Combined Signal (yields, durations, returns)
Alphas (expected returns) Risk Model
Constraints
Portfolio optimization
Optimal holdings
Building the alpha-driven portfolio – Signals
– We elaborate on the motivation behind our selected factors in the next section while here we briefly
outline our factor choices and the individual signals that we aim to initially develop to model these
factors
• Carry Factor: the factor aims to overweight (underweight) countries that offer a more (less) attractive income generation
potential via the yield earned by holding the respective sovereign debt assets.
• Value Factor: the factor aims to overweight (underweight) countries that offer a more (less) attractive capital appreciation
potential. Capital appreciation potential is based on measures of mispricing (i.e. relative cheapness or expensiveness). Value
anchors can be either purely based on term structure dynamics or more macro-fundamental in nature
Factor Category Signal
Carry Carry Carry
Rolldown
Slope Momentum
Curve-Based
Curve Momentum
Back-Front Mispricing
Value
Ten Year Risk Premium
Fundamental Risk Premium
Fundamental
Fundamental Risk Premium Momentum
Foreign Macro Premium
Private Consumption Growth
Economic Momentum Fixed Investment Growth
Fundamentals
Inflation
Central Bank Policy Fundamental Short-Rate Forecast
• Fundamentals Factor: real activity, nominal price pressures and monetary policy dynamics are a relevant factor too as they
can alter the relative attractiveness of assets that deliver a fixed nominal payment to investors (i.e. higher growth and the
resulting higher inflation erode the real return on nominal fixed income assets). We aim to measure this factor by focusing on
indicators that track the expected evolution of the real and nominal sides of the economy as well as the underlying stance of
monetary policy.
Building the alpha-driven portfolio – Signals
– What about other traditional factors often looked at in the literature on fixed income smart beta?
• Momentum: Value and Momentum by design should be significantly negatively correlated factors. The good: they
should therefore be highly diversifying to each other on an ex-ante basis. The bad: on a standalone basis our prior
is that Momentum should be a poor performer in this investment universe.
• Quality: our intended universe focuses on the more “IG” component of the DM space. Countries in this space are
quite homogeneous in terms of their sovereign credit profile. Our prior is therefore that this factor should
underperform here but it is worth examining for potential diversification benefits to other factors.
Smart beta portfolio construction: alpha signal example 1
– Investment hypothesis
While the shorter-end of the interest rate curve is primarily driven by expectations about near-term monetary policy, the longer-
end of the curve contains compensation for the risk that actual monetary policy might not evolve in line with market expectations
(i.e. the central bank might turn out to be more or less restrictive or accommodative than expected in the future). The signal uses
the slope of the curve (longer-dated yields less shorter-dated yields) as a proxy for this embedded risk premium. The signal
overweights (underweights) countries that offer more (less) attractive compensation for bearing this interest rate risk.
– Signal Design
1. For each country, obtain 2Y and 10Y government bond yields
2. Compute the simple difference between 10Y and 2Y yields (giving a simple proxy for bond term premium)
3. Exponentially smooth the series from 2. with a half life of 5 days
4. Exponentially score the series from 3. with their means and vols estimated with a half life of 260 days
5. Cap the directional scores from 4. at ±2
6. Cross-sectionally demean the series from 5. and preserve the score sign
Period Risk-adjusted return Annualized return % Annualized risk %

Full sample 1.07 1.07 1.00
First half 0.79 0.77 0.96
Second half 1.33 1.38 1.03
2009 0.62 0.65 1.05
2010 1.23 1.03 0.84
2011 0.42 0.59 1.42
2012 0.58 0.59 1.03
2013 1.67 1.01 0.60
2014 1.20 1.13 0.94
2015 0.11 0.13 1.20
2016 1.37 1.44 1.05
2017 1.62 1.51 0.93
2018 2.42 2.85 1.18
2019 1.18 0.80 0.67
Note: signal backtest monthly performance for the full-sample period January 2009 – October 2019. Risk-adjusted return is the ratio between the annualized backtest return and the
annualized backtest volatility over the relevant period.
Smart beta portfolio construction: alpha signal example 2
– Investment hypothesis
Accelerating economic growth and/or inflation are unfavorable for nominal fixed income. This operates through two channels: 1)
stronger growth/inflation increases the likelihood of future tighter monetary policy and 2) stronger inflation pressures would erode
the real return on an asset that pays fixed nominal income. The signal overweights (underweights) the sovereign debt of markets
with weaker (stronger) real activity outlooks and inflation pressures.
– Signal Design
1. For each country, obtain current year and next year Consensus Economics forecasts for private consumption growth, fixed
investment growth and consumer price inflation
2. Using the CY and NY forecasts from 1. construct a constant-horizon 12-month-ahead forecast in the respective indicator
3. Compute the 3-month change in the forecasts from 2.
4. Exponentially normalize the series from 3. with their volatilities estimated with a half life of 5 years.
5. Cap the directional scores from 4. at ±2
6. Cross-sectionally demean the series from 5. and reverse the score sign

Full sample 0.56 0.57 1.01
First half 0.62 0.69 1.12
Second half 0.49 0.45 0.91
2009 1.01 1.32 1.32
2010 0.94 1.25 1.33
2011 (0.33) (0.45) 1.36
2012 1.28 1.42 1.11
2013 0.21 0.15 0.70
2014 (0.06) (0.02) 0.29
2015 0.13 0.25 1.89
2016 2.39 0.97 0.41
2017 0.10 0.06 0.65
2018 0.75 0.37 0.49
2019 2.06 1.06 0.51
Proposed model: concepts, structure, results
Proposed model: what alpha model do we propose?
– Traded Assets: Nominal government bonds at the long-end (10Y) of the government bond term
structure
– Traded countries: a universe of nine developed markets
• North America: Canada, United States
• Europe: Germany, Norway, Sweden, Switzerland, United Kingdom
• Oceania: Australia, New Zealand
– Alpha Model
• Our alpha model recognizes the importance of Value / Carry as a dominant factor driving the above asset universe
• This is reflected in the relative overall weight that we place on Value / Carry in constructing our composite investment views
(see table below)
• We also recognize that when central banks start to adapt their policy stance Value / Carry would underperform
• We therefore also aim to model macro-fundamental dynamics (expected monetary policy, real activity, inflation)
Proposed model: what motivates our alpha model proposal?
• Understanding the long-term drivers of 1) the individual assets and 2) the overall asset universe should be a key input in
determining the ultimate factor mix in a multi-factor smart beta portfolio (i.e. “not all factors are created equal”)
• To that effect, we follow Adrian, Crump and Moench (2013) in decomposing zero-coupon 10Y government bond yields for the
United States and Germany into an expectations component (i.e. expected average short-term rate over the life of the bond)
and a compensation for the risk that short-term rates might not evolve as expected (i.e. term premium). See Appendix 2 for
results.
• We observe that
– For both USD and GER the long-end of the curve is driven predominantly by changes in compensation for risk, i.e. term premium
– Term premia appear to be positively correlated across countries
– Long-term market expectations of future short-term rates evolve slowly and contribute less to the volatility of the long end of the curve although in
certain episodes of aggressive central bank policy shifts they exert pressure on the long end too
• What are the investment implications?

– Value as an investable factor should reign supreme in our asset universe where 1) assets are predominantly driven by compensation for risk and 2)
where risk compensations are positively correlated across markets
– As a corollary, our prior is that momentum as an investable factor should struggle in this investment space
– Although we expect value to deliver over the long run there would be points in the cycle when it would struggle. These can be expected to coincide
with shifts in central bank policy in response to underlying macro dynamics. Therefore, performance consistency should benefit from the interplay
between the value and the fundamental factors → a case for a multi-factor alpha (and smart beta) approach
Proposed model: alpha model performance
The results reported below for the overall alpha model are in accordance with the model and backtest settings outlined on page 17

Full sample 2.17 2.23 1.03
First half 2.28 2.46 1.08
Second half 2.05 1.99 0.97
2009 3.35 5.00 1.49
2010 2.25 2.41 1.07
2011 1.15 1.50 1.30
2012 3.14 1.70 0.54
2013 3.13 1.81 0.58
2014 2.38 2.23 0.94
2015 1.43 2.11 1.48
2016 3.52 2.74 0.78
2017 1.67 2.08 1.24
2018 2.54 1.58 0.62
2019 2.26 1.51 0.67
Proposed model: from alpha model to smart beta model
– Benchmark Portfolio
• Equal weights across all assets (i.e. with nine assets that amounts to around 11.1% of total capital held in each country)
• We use equal weights here merely for ease of exposition and empirical analysis. In practice, the vast majority of benchmarks
would be debt-outstanding-based that would create heavy tilts towards certain markets such as the United States. In that
sense, our benchmark is more diversified and protected from country or regional risk.
– Alpha-driven Portfolio
• Structure as described on page 17 subject to optimization constraints as described on page 10
• We calibrate the alpha-driven portfolio to run at 20% of the annualized full-sample risk of the benchmark portfolio
• Long-term market expectations of future short-term rates evolve slowly and contribute less to the volatility of the long end of
the curve although in certain episodes of aggressive central bank policy shifts they exert pressure on the long end too
– Smart-Beta Portfolio
• This is the direct sum of the benchmark weight and the optimized alpha-driven weight for each asset
• We would like to emphasize that the particular design choices made in constructing the smart beta portfolio are for
illustration, can be subject to further consideration and might be different in practical implementations
Proposed model: benchmark and smart beta performance results
In the table below we present comparative results for the return and risk profiles of the performance of the benchmark portfolio and the smart
beta portfolio for the sample period January 2009 – October 2019. Graphical representations of performance and drawdown profiles are on the
next page.
Benchmark Smart Beta

Period Risk-adjusted return Annualized return % Annualized risk % Risk-adjusted return Annualized return % Annualized risk %
Full sample 0.87 5.6 6.5 1.27 8.2 6.4
First half 0.77 5.5 7.2 1.20 8.7 7.2
Second half 1.00 5.7 5.7 1.38 7.7 5.6
2009 (0.30) (2.1) 7.1 0.60 4.2 7.0
2010 0.90 7.1 7.8 1.34 10.6 7.9
2011 2.05 15.3 7.4 2.39 18.5 7.7
2012 1.35 9.1 6.7 1.68 11.5 6.8
2013 (0.79) (5.6) 7.1 (0.60) (4.1) 6.8
2014 2.94 13.7 4.7 3.28 15.7 4.8
2015 0.79 5.7 7.2 1.11 7.3 6.6
2016 0.28 2.1 7.6 0.64 4.9 7.8
2017 0.99 3.8 3.9 1.55 5.5 3.6
2018 0.24 1.1 4.7 0.59 2.7 4.5
2019 2.15 11.3 5.2 2.42 13.5 5.6
Proposed model: benchmark and smart beta performance results
Proposed model: from alpha model to smart beta model
– Developed Market Sovereign Smart Beta
• Include factor and signal ideas in our factor libraries offering
• Popularize our alpha and smart beta research in this investment space through the publication of regular market-oriented
commentary and updates
• Facilitate our sales efforts in promoting our alpha research capabilities as a basis for smart beta / ETF offerings
– Broaden our scope

• Our medium-term aim is to place our team and company on a steady trajectory to becoming an industry-established hub for
systematic alpha and smart beta quantitative investment research
• We believe that broadening the scope of our research to cover a wider spectrum of market segments is a key step in that
direction
• Investment asset classes that we would like to focus our systematic alpha and smart beta efforts on in the near- to medium-
term include:
– Fixed income: 1) emerging market sovereign debt; 2) developed market corporate debt
– Foreign exchange: 1) developed markets; 2) emerging markets
– Equities: global cross-country opportunities
We would like to emphasize that the particular design choices made in constructing the smart beta portfolio are for illustration,
can be subject to further consideration and might be different in practical implementations
Appendix
Appendix 1: Asset returns calculation
• We calculate 10Y asset returns using the in-house zero-coupon government bond curves that are available daily using the
steps described below
• Below we work with an example based on German zero-coupon curves based on two randomly selected consecutive first-
business-day-of-the-month dates as given in the table
GER zero-coupon rates (%)

Dates 10Y rate 9Y rate
20150101 0.59 0.46
20150202 0.31 0.23
• As we work with zero-coupon bond data we assume that the duration is equal to the maturity (i.e. 10)
• Calculating monthly GER 10Y asset returns for the period 1 January 2015 - 2 February 2015\
– Due to yield changes: - (0.31 - 0.59) x 10 = 2.80%

– Due to carry: 0.59 x (1/12)  0.05%
– Due to rolldown: (0.59 – 0.46) x (1/12) x 10  0.11%
– Full return  2.80% + 0.05% + 0.11% = 2.96%
Appendix 2: decomposing USD and EUR zero-coupon government rates
Note: results are based on own replication code and calculations. Results are for the period September 2004 – August 2019.

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Systematic Developed Market Sovereign Fixed Income

• Building A Smart Beta Portfolio

• Proposed model: concepts, structure, results

– Current FI ETF market landscape

Smart Beta Indexes

Non market-capitalization weighted

Fundamental Weighted Minimum Variance Single Factor

Equal Risk Contribution Maximum Sharpe Ratio

– Alpha-driven portfolio as an overlay on top of the benchmark portfolio

Raw signal data

Alphas (expected returns) Risk Model

Period Risk-adjusted return Annualized return % Annualized risk %

Period Risk-adjusted return Annualized return % Annualized risk %

• What are the investment implications?

Period Risk-adjusted return Annualized return % Annualized risk %

Benchmark Smart Beta

– Broaden our scope

GER zero-coupon rates (%)

– Due to yield changes: - (0.31 - 0.59) x 10 = 2.80%

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