Time for insurance investors to embrace systematic fixed income? | Insight Investment

First things first, what is systematic investing and how may a strategy differ from a traditional approach?

Paul: We see it as a rigorous, mathematical rules-based approach to active management. So, its “quantitative” rather than “discretionary”, which perhaps describes more traditional strategies that feature some level of a qualitative approach.

Quant approaches operate according to a well-defined system that we can execute technologically using computer programs.

That said, there are many ways to skin a cat, and other managers may see things differently. For example, some systematic approaches use what they call a “quantamental” approach, a word derived from “quantitative” and “fundamental”, which aims to combine both quantitative and discretionary approaches. We are more purist about things, preferring something closer to a fully quant approach that takes all the “emotion” out of investment decisions.

We and our clients see systematic investing as a complement to their discretionary investment portfolios as it can lead to different-looking portfolios. 

But the beauty of computers is that they are tireless and can operate close to light speed. So, if we can construct a model to analyze a bond, we can run it repeatedly and quickly across an entire universe. So, our strategies typically take more numerous and more diverse alpha positions than most traditional strategies, which tend to focus their alpha positioning on a more limited sample of credits that a manager has the resources to hire credit analysts to cover.

This difference in approach also tends to create excellent opportunities to reap the benefits of diversification. Our broad high yield strategy, for example, has had an alpha correlation of less than 0.25 with 90% of the fundamental active US high yield manager universe and a negative correlation with 60% of it¹.

Can you provide some background on how systematic strategies developed?

Paul: Yes, they have a rich history. In the 1960s in my hometown of San Francisco, a gentleman called John McQuown assembled a dream team of data-driven revolutionaries, or quants, to challenge the traditional ways of investing in stocks. In the 1970s, two gentleman, Bill Fowles and Tom Lowe, spun out of this team to run the first equity indexing strategy. I was fortunate enough to work with Tom for a while and got to meet Bill Fowles at our annual Christmas meetings.

Fast forward to the 1990s, Fama and French first published their famous three-factor model. This kicked off the factor-based investing in equites. Today, there are even online communities about building systematic equity strategies that really anybody can participate in.

Fixed income was left behind until the last decade but has now really come of age. We have been there since the beginning, building and refining our systematic fixed income approach since 2001.

Why have did it take so long for systematic strategies to come to prominence in fixed income?

Paul: It really comes down to liquidity. You can trade equities at a penny-wide spread, making it easy to set up a model-based approach. But in bonds, OTC trading is expensive.

However, the rise of fixed income ETFs has changed the game. We were a pioneer of “credit portfolio trading”, which in our experience may lower global investment grade transaction costs from around 30bp to around 20bp and US high yield transaction costs around 60bp to as little as 15bp. An additional benefit is that this can allow us to receive the “illiquidity premium” embedded in high yield credit spreads for “free”, given we find we can trade them fluidly and efficiently.

How does credit portfolio trading work?

Paul: Instead of trading bonds one at a time, credit portfolio trading involves trading “baskets” of bonds, potentially 500 or 1000 at a time, with counterparties that are tightly integrated into the ETF ecosystem.

Essentially these counterparties can treat our trades in the same manner they would think about diversified in-kinds into and out of ETFs, because they look and feel similar to the indices they’re tracking. We can still add our underweight and overweight tilts into every basket, to match our desired portfolio exposures. It’s important to note that we’re not trading ETFs themselves, we’re working within the underlying ETF ecosystem to transact in a specific way.

Our high yield strategies often hold as much as 90% of the bonds in a high yield index, whereas most traditional active strategies hold only 15% to 30%². 

We find we can transact $500m per day, generally executing within minutes or hours. We find a trade can be as large as $500m or as low as $5m for exactly the same diverse basket of bonds.

What benefits does systematic high yield offer for insurance companies?

Paul: As we know, insurance companies have lots of constraints and unique requirements.

For our high yield ETF strategy, we engaged the SVO to receive NAIC designations. Typically, ETFs are treated as equities for regulatory reporting purposes, but an NAIC designation often allows clients to treat them as bonds for regulatory reporting purposes, given the underlying assets are bonds. For us, it was important to make the strategies as investable as possible for insurance general accounts.

Having said that, in some states an NAIC designation may not be able to classify ETFs in a capital-efficient way. But we can achieve the look-through for regulatory capital purposes through separately managed accounts.

Separately managed accounts also often work for our clients because, while ETFs constrain investors to a certain benchmark, separately managed accounts can be customized. And I think one of the main benefits for insurance companies is how customizable systematic strategies are.

So are your systematic SMAs customizable for each insurance client?

Paul: Yes, very much so. Ultimately, our models are benchmark-agnostic, so we can really rely on our clients to tell us what their constraints, concerns and desires are. For example, we have international insurance clients whose capital penalty is highly correlated to duration. So we can target a portfolio of high-yield bonds concentrated in maturities of less than three years. Or if there's a similar client that has an aversion to CCC bonds, we can construct a double-B and single-B portfolio that is highly diversified. We're not tied to the strengths of our credit analysts.

We are seeing more and more clients embrace systematic approaches for both strategic and tactical allocations.

Are there any observations you have regarding how have your insurance clients have tended to incorporate your systematic strategies?

Paul: Our clients have incorporated our strategies both strategically and tactically.

On the strategic side, we find many insurance clients are sensitive to gains and losses, so they prioritize income and capital preservation. So many of our clients use our strategies as strategic income generators. Because we can build highly diversified portfolios, defaults are less of a concern for us than they might be for more traditional managers, so we perhaps have a greater ability to embrace default risks where we think credit spreads offer ample compensation for the risks.

Tactically, we increasingly have clients using our systematic high yield strategies to dial risk up or down efficiently based on either their risk-based capital position or to take advantage of tactical opportunities. Insurance companies are certainty no longer the “sleepy” investors that is often dictated by the stereotype, but to be tactical in high yield, you need a high degree of liquidity so that you can move assets quickly, and you need to be very watchful about transaction costs, so that you don’t leave behind all the alpha on a great tactical move.

Insight’s team has been managing insurance assets for more than 30 years. We have watched them evolve as the investment opportunity set has expanded. We believe our clients benefit from open access to an extensive pool of investment professionals including portfolio managers, research analysts, actuaries and solution designers. We like to work in partnership with our clients and strive to be an extension of their team.

Paul Benson, CFA, CAIA - Head of Systematic Fixed Income, Insight Investment

Paul has 30 years’ experience in the investment industry. He joined BNY Mellon Investment Management affiliate, Mellon Investments, in 2005 and has been Head of the Systematic Fixed Income Team since 2015. In September 2021, Mellon Investments’ fixed income strategies, including the Systematic Fixed Income Team, formally joined Insight.

Based in San Francisco, Paul and his team of portfolio managers, researchers and traders pioneered the development of highly implementable systematic fixed income strategies by combining innovative model-driven alpha research with cutting-edge trading technology.

Before becoming Head of the Systematic Fixed Income Team, Paul was a senior portfolio manager responsible for the yield curve arbitrage strategy within global asset allocation portfolios. Additionally, he engineered and built the process to automate fixed income portfolio rebalancing and improve operational risk control. Prior to joining Mellon Investments, Paul was a senior fixed income portfolio associate at Pacific Investment Management Company (PIMCO), where he analyzed, implemented and managed active US and global fixed income portfolios. Previously, he was a trader at Westdeutsche Landesbank Tokyo, where he built the interest rate swaps trading desk, and a trader at Bankers Trust Tokyo, where he ran the Japanese government bond book. Both positions included market making and proprietary trading. Paul received a BA from University of Michigan at Ann Arbor. He is a CFA charterholder and is a member of the CFA Institute.