Bringing Momentum to Bond Investing

by: , Chief Investment Officer and Managing Director | IndexIQ

As Isaac Newton noted, objects in motion tend to remain in motion until something comes along to disrupt them.

This same principle has long been recognized by stock investors as a valuable tool. The strategy, known as momentum investing, seeks to overweight securities that have done well in the recent past and underweight those that have done poorly on the presumption that these trends have persistence in the market. There’s substantial evidence on the stock side that this is the case. In one study¹, the researchers found that for many equity managers, so-called smart beta factors—including momentum—accounted for more than 40% of the active risk taken.

If it works with stocks, what about bonds? Would an investor with an allocation across a broad range of fixed income categories including government bonds, mortgage-backed securities (MBS), and corporate bonds benefit from a momentum strategy? Studies² using historical simulation to compare a momentum-driven approach to a classic long-only approach suggest that it is possible to enhance returns over time using momentum, without exposing the portfolio to increased downside risk.

As with equities, the strategy seeks to leverage a number of well-established principles about both markets and human behavior. This includes the impact of fund flows and the recent negative correlation between stocks and bonds that has investors de-risking their portfolios by moving into fixed income.

In today’s low interest world, income-oriented investors need every advantage they can get. And, of course, the prospect of more Fed tightening hangs over the bond market as well. Importantly, the strength of fixed income momentum does not appear to be dependent on the overall direction of either bond or equity markets, and it is not strongly correlated with the performance of equity momentum strategies either.

One way to put this strategy to work is through a rules-based approach designed to overweight recent winners and underweight recent losers, while not triggering excessive trading and its associated costs. ETFs provide a vehicle for putting this into practice in an efficient, low-cost manner. The two ETFs recently introduced by IndexIQ are the first real-world implementations of a rules-based momentum strategy in the bond world.

No strategy is without some risk, and that holds for momentum-based investing as well. By design, it tends to overweight securities that are in favor and underweight the securities out of favor. When there are sudden shifts in sentiment or market liquidity, momentum portfolios may underperform. But all investing involves a balance between risk and reward. In this case, momentum could be viewed as a risk factor added to a diversified portfolio of bonds—the return premium it seeks to deliver over the longer run is the compensation for that risk.

About risk:

As with all investments, there are certain risks of investing in the Funds. The Funds’ shares will change in value and you could lose money by investing in the Funds. The Funds’ investment performance, because they are fund of funds, depends on the investment performance of the ETPs in which they invest.

Funds that invest in bonds are subject to interest rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner. The principal risk of mortgage-backed securities is that the underlying debt may be prepaid ahead of schedule if interest rates fall, thereby reducing the value of the Funds’ investment. If interest rates rise, less of the debt may be prepaid and the Funds may lose money.

The value of the Funds’ investment in ETPs is based on stock market prices and the Funds could lose money due to stock market developments, the failure of an active trading market to develop, or exchange trading halts or de-listings.

As new funds, there can be no assurance that they will grow to or maintain an economically viable size, in which case they may experience greater tracking error to its Underlying Indexes than they otherwise would at higher asset levels, or they could ultimately liquidate.

Smart beta defines a set of investment strategies that emphasize the use of alternative index construction rules to traditional market capitalization based indices.

1. Kahn and Lemmon (2016) studied fund manager correlations to 6 “smart-beta” factors for equities (market, size, value, quality, low volatility and momentum) using Barra’s risk model.

2. Durham, J.B., 2015. “Can Long-Only Investors Use Momentum to Beat the US Treasury Market?”, Financial Analyst Journal, vol. 71, no. 5

Consider the Funds’ investment objectives, risks, and charges and expenses carefully before investing. The prospectus and the statement of additional information include this and other relevant information about the Funds and are available by visiting IQetfs.com or calling 888-934-0777. Read the prospectus carefully before investing.

MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the IQ Hedge Multi-Strategy Plus Fund. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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Salvatore J. Bruno

Chief Investment Officer and Managing Director | IndexIQ

Sal is Chief Investment Officer at IndexIQ, where his primary responsibility includes developing and maintaining the firm’s investment strategies. Sal joined IndexIQ in 2007 from Deutsche Asset Management (DeAM) where he held a number of senior positions

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