The Big Idea

Risk, reward and betting against beta

Steven Abrahams | August 16, 2024

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Anyone can take risk, but making it pay—or at least making it pay more than a fair return—is a much tougher job. Adding some extra duration, deepening credit exposure or leaning into other systemic risks can drive up return, but returns at the far reaches of risk often fall below fair value. For at least the last year and probably much longer, the best actively managed mutual funds have made risk pay by doing just the opposite and diversifying away from systemic risk. Those funds have delivered clear excess return and have been rewarded by faster growth in assets under management.

Over the last year, the haves and have-nots among actively managed US bond mutual funds with more than $10 billion in assets have split along the scale of risk, at least when it comes to delivering excess return or alpha. Funds with returns less risky or volatile than the Bloomberg Aggregate US Bond Market Index—funds with an average beta of 0.95, or 5% less volatile than the index—have outperformed index returns by an average of 2.5 bp a week (Exhibit 1). Funds with returns more risky or volatile than the broad market, on the other hand—funds with an average beta of 1.04, or 4% more volatile than the index—have beat the index by an average of 0.5 bp a week. The link between risk or beta and excess return or alpha is very clear, at least over the last year. Funds than favored lower levels of risk, in other words, provided five times the weekly risk-adjusted return of their higher risk peers.

Exhibit 1: Low beta bond funds have delivered better risk-adjusted returns

Note: Return alpha reflects the value of the intercept from regressing weekly returns from each fund on weekly returns from the Bloomberg Aggregate US Bond Market Index over the last year. Data includes 27 open-ended mutual funds with $10B or more in assets primarily indexed to the Bloomberg Aggregate US Bond Market Index.
Source: Bloomberg, Santander US Capital Markets

Excess returns have mattered for the ability of these funds to attract assets. Funds that beat the broad market after adjusting for risk have grown AUM year-to-date by 6.7% while funds that trailed the market have grown year-to-date by 5.5% (Exhibit 2). Some funds that clearly underperformed the index have seen AUM drop despite strong net inflows to mutual funds this year. This is consistent with other work (here) showing mutual fund investors often chase funds with relatively good returns and flee funds that underperform.

Exhibit 2: Funds delivering excess return have grown AUM faster

These recent results from mutual funds also line up with a long list of other studies (here, for example) showing that high beta portfolios routinely deliver less than fair value for the risk taken. One explanation of the result argues that limits on true financial leverage—the inability of many funds to leverage risk exposure through borrowing, such as the leverage limits that apply to mutual funds under the Investment Company Act of 1940—forces portfolios to leverage risk exposures through high beta assets. In other words, a portfolio that wants to take more interest rate risk will buy 10-year notes instead of financing a position in 2-year notes. Or a portfolio that wants to take more credit risk will go into ‘BBB’ assets instead of leveraging a position in ‘AA’ assets. Capital crowds into high beta assets and leaves them relatively overvalued while low beta assets end up undervalued.

Of course, it is not all beta. Other factors have contributed to excess return among large actively managed mutual funds. Beta has had the largest influence, with a correlation of -0.92 to 1-year alpha—the higher the beta, the lower the excess return (Exhibit 3). Portfolio duration at the start of the year has had a -0.45 correlation—the longer the duration, the lower the excess return. Higher allocation to MBS and Treasury debt has also tended to lower excess return while higher allocation to cash and corporate debt has tended to raise excess return.

Exhibit 3: Beta and duration trimmed excess return, but allocation mattered, too

Note: Fund asset allocation as of 8/15/2024 as determined by Bloomberg. Return alpha reflects the value of the intercept from regressing weekly returns from each fund on weekly returns from the Bloomberg Aggregate US Bond Market Index over the last year.
Source: Bloomberg, Santander US Capital Markets.

The practical implications of betting against beta argue for keeping beta relatively low and spending more time on strategies arguably independent from beta—relative value first and other approaches such as momentum, liquidity or out-of-index exposures second. In a mutual fund portfolio, for example, that might mean a default position of running duration a little short of benchmark, credit quality a little higher and credit spread duration a little lower than benchmark with MBS spread duration below benchmark and MBS convexity above. That kind of portfolio will likely spin off less income than the benchmark, but any systemic volatility would likely generate price returns better than the index. The manager could supplement a low beta default position by focusing on security selection, momentum trades and holding some less liquid positions. Out-of-index positions would also bring in diversifying risk, and lower beta in the process.

Mutual fund managers that have figured out how to get paid more than fair value for risk lately have seen a tangible payoff through faster growth in AUM. That makes betting against beta and spending more time on relative value and other diversifying approaches sound like more than an academic discussion. At least for fund managers, that all just sounds like good business.

* * *

The view in rates

Still bullish on rates, both short and long. As of Friday, fed funds futures priced in 96 bp of easing this year—just off 4 bp from a week ago. This follows the July CPI report that showed core up 0.2% month-over-month, not low enough to push the Fed toward a 50 bp September cut and not high enough to push cuts out further. The market now prices slightly more than a full 25 bp cut in each of September, November and December. That should put the Fed into full easing mode, and the expected and realized cuts should continue to drag down both short and long rates, although not all equally.

Other key market levels:

Fed RRP balances closed Friday at $330 billion. RRP balances bounced between $400 billion and $500 billion from the start of March until seven weeks ago. Better yields in T-bills and bilateral repo keep drawing cash away from the RRP.
Setting on 3-month term SOFR closed Friday at 513 bp, up 2 bp in the last week following the sharpest drop the week before since the collapse of Silicon Valley Bank in March 2023.
Further out the curve, the 2-year note closed Friday at 4.06%, up 1 bp in the last week. The 10-year note closed at 3.89%, down 5 bp in the last week.
The Treasury yield curve closed Friday afternoon with 2s10s at -17, flatter by 6 bp in the last week. The 5s30s closed Friday at 39 bp, flatter by 3 bp over the same period
Breakeven 10-year inflation traded Friday at 208 bp, down 3 bp in the last week. The 10-year real rate finished the week at 181 bp, down 2 bp on the week.

The view in spreads

Implied volatility has come off the peaks the followed the weak July payrolls. That should marginally help spreads in risk assets. Credit still has momentum with a strong bid from insurers and mutual funds, the former now seeing some of the strongest premium and annuity inflows in two decades and the later getting strong inflows in 2024. The broad trend to higher Treasury supply also helps in the background to squeeze the spread between risky and riskless assets. Nevertheless, high rate and equity volatility have pushed credit and nominal MBS spreads wider.

The Bloomberg US investment grade corporate bond index OAS closed Friday at 96 bp, tighter by 6 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 140 bp, tighter by 5 bp on the week. Par 30-year MBS TOAS closed Friday at 33 bp, tighter by 3 bp on the week. Low supply is helping keep MBS spreads relatively tight.

The view in credit

The prospect of lower interest rates should slowly relieve pressure on the most leveraged corporate balance sheets and office properties. Most investment grade corporate and most consumer sheets have fixed-rate funding so falling rates have limited immediate effect. Rising unemployment should put pressure on consumers, but high levels of home equity and investment appreciation should buffer the stress. Other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. US banks nevertheless have a benign view of credit in syndicated loans. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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