ANTI-INFLATION AND CORE-BOND SUBSTITUTE SOLUTIONS BY QAS
ANTI-INFLATION, CORE-BOND SUBSTITUTE AND CAPITAL PROTECTION: EFFECTIVE QAS HIGH-YIELD BOND SOLUTIONS FOR INVESTMENT ADVISERS
Introduction
QAS’s global model portfolio program continued to grow and expand in 2021. Our high-yield bond strategies are becoming increasingly popular among investment professionals world-wide, generating close to $30 Mln in AUM in a 2-yr period.
QAS 128 Global High-Yield Bond with Max Protection vs. HYG, SHY, AGG (2016-2021)
High-yield bonds are usually avoided by financial advisors because of the embedded “high-risk” profile associated with these instruments (low credit ratings, equity-like volatility etc). Historically, high-yield bonds have been used more by institutional managers. Therefore, by introducing an innovative risk-controlled ETF/Fund –based solutions to investment advisers world-wide, we are changing the paradigm by making these instruments available to the retail investment community.
In early August 2021, we conducted an interview-discussion with our strategic partners in the US and UK who successfully implement our “high-yield bond” strategies on their investment platforms in the forms of separately-managed accounts (SMA) and a UCITS fund.
We would like to share with you their thoughts, experience and feedback in regards to our high-yield bond investment solutions.
The following people participated in our discussion:
[BA] Barry Arnold
Sr. Portfolio Manager & Director of Research
Global View Capital Management, LTD
Waukesha, WI, USA
[DM] David Morton
Portfolio Manager
Global View Capital Management, LTD
Waukesha, WI, USA
[IH] Ian Hart
Investment Director
Unbiased Portfolio Management LTD
London, UK
[SM] Steven Malinsky
EVP Business Development
Quantitative Analysis Service, Inc
Newark, NJ, USA
Global Macro Challenges
[SM] Welcome to our feedback-discussion! I would like to begin with an overview of the main risk topics as they were recently reflected in the financial media, such as: Covid/Delta virus spike, inflation, low global yields environment, yield spikes, growth concerns and more.
What do you think are the main concerns that global investors are facing today?
[IH] To me, the rising cases of the Delta variant seem to be the biggest problem today. We, as a country (UK), have good results in regards to vaccination. I believe at this point nearly 90% of the adult population have at least one shot.
Overall, fixed income fundamentals remain healthy, supported by strong economic data. The central banks’ policies and vaccination programs helped to avoid fresh lockdowns. There is clear evidence that the major developed countries are having some economic tailwinds due to successful vaccination programs, while the rest of the world is not doing as well.
As I said, the key thing for us in the UK is we are all focused on pandemic and if we can travel. The #1 concern here is “when can I go on a holiday?”, and if I can go on a holiday, can I come back to the UK?”
[BA] On our side in the US, our clients are definitely concerned about potential lockdowns, reopening issues, and news such as “airlines may start requiring passengers to get vaccinated”. This would likely reduce the number of people who would like to travel. But, from a financial adviser standpoint, it’s more about inflation. We conducted several webinars already in purpose to provide our clients with necessary information about how we are being proactive in protecting their portfolios from potential negative effects of inflation.
[DM] I agree with you, Barry. I think our financial advisers are super alarmed about inflation as well as other disturbing news. They often reflect their anxiety and concerns, and unfortunately sometimes pass them to our clients. So, we have to temper that tendency. And the best way to do that is to provide them with real solutions that would work whichever way the economy and markets go.
[SM] I wanted to show you two charts: one is reflecting the current yields around the world, and another one is showing a growing inflation trend in the US.
As you can see, global bond yields are currently at very low levels, while the German 10yr Bund is in negative territory, and Japan’s 10yr bond has been near zero for a long time as well. At the same time, the US Inflation Rate has been increasing sharply up to a 5.4% level in 2021. We see the inflation rate rising globally as well. This combination is having a very negative impact on investors’ cash and savings positions.
[BA] I would like to point out one thing. We have negative real rates right now. Why would you keep money under the mattress during the inflationary times when you lose purchasing power? However, during this period of searching for positive returns, the equity market, with all of its volatility, is the only “game in town”. Therefore, the whole area of “high-yield” becomes more attractive as an alternative to the equity markets.
Why We Build High-Yield Bond Strategies?
[SM] There are many interesting sides of the global high-yield bond instruments that we wanted to emphasize for retail investors. Amongst various points, we noticed some advantages in the intrinsic characteristics of these bonds that could potentially play well in our favor. Let’s discuss some “nuts-and-bolts” of the high-yield bond investment.
[IH] I would begin with some comparison analysis. From a fundamental point of view, “double-Bs” (BB) bonds have done better than “single-Bs” (B). That is, again, because the delta variant is worrying the markets a bit, and treasury yields have “backed off”, certain sectors have done better.
The “Yield-to-Worst” ratio in various categories is as follows:
“BB” – 3.11
“B” – 4.50
“CCC” – 7.02
If combined into the high yield index, the “Yield-to-Worst” ratio is 3.93.
Also, the medium spread of the high-yield index over LIBOR in the last 15 years is 4.77, at times it was 2.41 and currently it is about 3.22.
It is important to mention that because a high-yield bond is shorter in duration (typically 2-4yrs) vs. for example a 7-10yr Treasury bond ETF (7.9yrs), it is less sensitive to interest rate changes.
Also, because of its low-duration characteristics, it doesn’t wobble as much as treasuries. Overall, we could make a key observation that a high-yield bond is technically less affected by interest rates, inflation factors, and has lower volatility.
[SM] This makes a high-yield bond a very effective investment vehicle during various stressful economic periods.
[IH] I can bring some examples of difficult market scenarios when treasuries failed to work as expected.
Take a look at a conventional 60/40 portfolio structure. Investors take substantial exposure in treasuries to curb the impact of equity’s volatility. However, when the treasury yields are low (as we have today), they can’t go much lower. Because of that, treasuries are not doing the job right, or simply cannot reduce a portfolio’s volatility.
Also, March of last year (2020) was a good example. We look at 3 instruments: dollar, gold and treasuries. On March 9th of 2020, Saudi Arabia decided to start an oil price war with Russia. As a result, investors a) bought dollar b) sold gold and c) sold treasuries. Therefore, in times of distress, treasuries failed to provide help or safety when it was really needed.
In both scenarios, our risk-controlled high-yield bond solution would be very helpful.
[SM] We currently maintain two high-yield bond strategies:
- S-126 US High-Yield 50/50-30 Rotation Strategy
- S-128 / 205 Global High-Yield Bond with Max. Protection Strategy
Both strategies implement our proprietary 3-regime allocation system (Positive-Aggressive, Neutral-Cautious and Negative-Defensive). The main idea was always to provide the best possible returns while managing risk and protecting the investor’s money from drawdowns.
Our QAS S-126 model was specifically designed with two distinctive investment objectives:
- Outperform balanced 60/40 or 50/50 “US High-Yield ETF (HYG)/7-10yr US Treasury ETF (IEF)” portfolio by providing less volatility to the HYG component.
- Outperform relative to the AGG (aggregate core-bond) ETF by creating a synthetic core-bond exposure with a “HYG/IEF” symmetric rotation.
This makes this strategy more versatile from a marketing perspective. We should make advisers aware of all of the model’s features, so they can start using it more for their core-bond exposure needs.
Both strategies were successfully implemented globally via customized risk-controlled solutions.
Feedback From Strategic Partners
[DM] When I look at all these economic problems and concerns by investors, I see both QAS strategies (US and Global High-Yield) as a solution that addresses them. These strategies have so many features that shine at different times. And most importantly, based on our experience with them, they act exactly as expected “by design”. Both strategies outperformed benchmarks with significantly lower volatility.
I think this investment theme has a great concept. We explain this to our clients as a multi-regime tactical strategy. They understand that there are “good times” when we need a positive regime for maximum capital gains, and there are “bad times” when we need a negative regime for capital protection. Sometimes we use terms “bullish regimes” and “bearish regimes”.
I often use this analogy: would you recommend to your child to drive at the same speed on the highway all the time? It is definitely dangerous advice, because there are zones with different speed limits. This is the same way we have to approach investment in a high-yield bond. That is why QAS’s multi-regime allocation scheme makes sense.
[BA] I would like to add that when I spoke with some other experts who use high-yield bonds in their investment products – they noticed that historically these instruments provide amazingly clear and smooth signals over time.
It is worth mentioning that according to our internal platform’s risk metrics that go from 0 (safe) to 100 (aggressive), the HYG ETF has a score of 70, while the QAS high-yield bond strategies’ score is only 30-35. This makes financial advisers much more comfortable using these instruments from a risk management perspective. Think about the fact that our typical equity strategy has a score of 70-80, and by blending together with either of the QAS high-yield bond strategies, it takes the overall client portfolio risk score down to 40-50. It’s a beautiful thing.
[SM] I have a good example based on our live historical performance, illustrating how our quantitative 3-regime algorithm effectively worked through a stressful period during March 2020.
As you can see, our Global High-Yield strategy successfully avoided significant drawdown and generated a nice excess return for our clients. This is true risk management in action. Overall, this strategy managed to keep a volatility level below 5%.
[BA] I wanted to add to your point that during this period the S&P 500 had a drawdown of -26%, and HYG -20%, while our strategy was down only by -3%. The defensive mechanism worked well, exactly as expected.
Both QAS high-yield strategies have great traction on our platform. Our financial advisers love to offer them to clients of all portfolio sizes.
[IH] We’ve had a similar experience with the QAS Global High-Yield bond model. We, in the UK, adapted a different or customized version of this strategy using multiple providers’ UCITS funds to gain global high-yield exposure (as opposed to an ETF-based solution that was designed for the US platform).
Our fund is up +4.3% YTD vs. HYG +2.9% with less volatility (as of 08-06-21). This is evidence that this active tactical strategy seems to do better than a “static-passive” ETF.
[SM] Ian, I had a question for you. In your marketing materials, created for the UK-based investor, you mentioned that the Global High-Yield fund solution is a good potential substitute for the following investment categories:
- Cash or savings
- Absolute return
- Property
- Alts
- Conventional Safe Haven (Treasuries, Gold)
Can you elaborate on this topic?
[IH] Sure. In essence, it’s extremely smooth. So, from the efficient frontier perspective, you would use these different instruments’ exposure to reduce an equity portfolio’s volatility. In this case, why don’t you add a global high-yield fund with extremely low volatility (under 5%) to the mix?
However, the main reason why we built this product in the first place was because here in the UK we have individual tax-free savings accounts called “ISAs” with roughly 600 Billion Sterling invested across the nation. It’s an investment product, but half of this amount is held in cash that technically is not generating any returns. As you can imagine, with rising inflation today, people are actually losing money. So, this is why I want to offer my global high-yield fund as a solution that is not “equity-based”, that has much lower volatility, and provides investors with a consistent positive return generation process.
[DM] In the US, we would compare this situation with our 401K investment choices such as “target-date”, “stable value” and “money market” fund families. In many cases, after investing in these funds for decades, people end up with low or no returns, especially if you take into consideration the real rates, inflation impact and massive fees that these funds are charging. We are talking about trillions of dollars invested in these funds.
[SM] In our final segment, can you describe your overall experience with QAS products and what are your expectations for the 2nd half of 2021 and beyond?
[IH] I would be happy to start. Since our fund was launched, we have not missed a heartbeat. We’ve always had reliable deliveries from QAS production on a daily basis. That is certainly the key point for me as I use UCITS funds as underlying instruments. The timely delivery of the quantitative reports from QAS gives me a necessary comfort in actual pre-market analysis and trade execution.
From a marketing activities perspective, I am looking forward to going back to “business as usual” as the whole UK is opening up in September. I will be able to fully execute my sales strategy via live meetings and professional events.
[BA] Our experience with QAS has been outstanding. We receive our daily, weekly and monthly reports from QAS in a timely manner. I am very happy with the “rhythm” of QAS’s quant signals. I love the regime-based methodology. In regards to trade execution, we were able to streamline our process in a way that it literally takes just seconds to push through all of the models’ updates across the hundreds of “SMA” accounts that are invested in QAS strategies. As far as going forward, we are having a lot more financial advisers asking about the entire suite of fixed income solutions. We always highlight QAS high-yield bond strategies as a very effective part in portfolio diversification. We expect more traction and growing AUM in these strategies since the track records have been great.
[DM] I would say one thing. As a firm, I’ve had the luxury of following QAS’s work for a long time. I had the chance to learn more about this firm’s history, their methodology and how they operate. We interacted with QAS on multiple projects before they even started implementing their model portfolio program on our platform. From a business standpoint, this firm has been “rock solid”.
In terms of the investment area, the QAS strategies are always doing what they are expected to do. Year after year, we witness that these quant models behave in line with expectations. And that’s all you can really ask. We expect nice growth going forward.
[SM] Thank you all for your great feedback. Here are the main points derived from today’s discussion:
- QAS’s high-yield bond solutions have become successful customized global investment products.
- Our innovative high-yield bond solutions are made available to retail investors through our strategic partners in the US and UK via SMA and UCITS fund products.
- The strategies deliver great performance and low volatility, as expected by design.
- The strategies work well in capturing maximum capital gains while providing superior risk management, especially during challenging economic periods.
- There are many ways investors can use our strategies in their portfolio construction.
As of 08-23-21, the current regimes for the models were as follows:
- S-126 US High-Yield / 7-10yr US Treasury Rotation — Neutral, 50/50 allocation (initiated on 08-11-21).
- S-128/205 Global High-Yield Bond with Max Protection — Defensive, 90-100% 1-3yr US Treasury Allocation (initiated on 08-12-21).
For more information, please contact QAS and its strategic partners in the US and UK.
