Big Data in Fixed Income Markets? Scott Richardson, Ph.D. November 23, 2018 Private and Confidential For Institutional Investor Use Only Disclosures The information set forth herein has been obtained or derived from sources believed by AQR Capital Management, LLC (“AQR”) to be reliable. However, AQR does not make any representation or warranty, express or implied, as to the information’s accuracy or completeness, nor does AQR recommend that the attached information serve as the basis of any investment decision. This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such. This document is intended exclusively for the use of the person to whom it has been delivered by AQR and it is not to be reproduced or redistributed to any other person. Please refer to the Appendix for more information on risks and fees. For one-on-one presentation use only. Past performance is not a guarantee of future performance. This presentation is not research and should not be treated as research. This presentation does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the speaker nor AQR undertakes to advise you of any changes in the views expressed herein. It should not be assumed that the speaker will make investment recommendations in the future that are consistent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein in managing client accounts. AQR and its affiliates may have positions (long or short) or engage in securities transactions that are not consistent with the information and views expressed in this presentation. The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the speaker guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Target allocations contained herein are subject to change. There is no assurance that the target allocations will be achieved, and actual allocations may be significantly different than that shown here. This presentation should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy. The information in this presentation may contain projections or other forward‐looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this presentation, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Performance of all cited indices is calculated on a total return basis with dividends reinvested. The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation. Please note that changes in the rate of exchange of a currency may affect the value, price or income of an investment adversely. Neither AQR nor the speaker assumes any duty to, nor undertakes to update forward looking statements. No representation or warranty, express or implied, is made or given by or on behalf of AQR, the speaker or any other person as to the accuracy and completeness or fairness of the information contained in this presentation, and no responsibility or liability is accepted for any such information. By accepting this presentation in its entirety, the recipient acknowledges its understanding and acceptance of the foregoing statement. 2 Big Data in Fixed Income Markets? AQR Fixed Income Investment Philosophy Digging Deeper: Value Investing in Fixed Income Machine Learning Use Case: Does Fundamental Volatility Help Explain Credit Risk? 3 AQR Fixed Income Investment Philosophy Systematic Investing in Fixed Income No data, no Fama French factors Systematic approaches are relatively new to fixed income: • Limited corporate bond data on traded prices/t-costs until TRACE (2002) • Less tractable than equities (term-structure, seniority, multiple issues, other structural differences) Timeline of US Bond Price Dissemination Lehman Brothers: Lehman Brothers: TRACE: Publicly First Total Return Bond-Level Index Disseminated Traded TRACE: MBS Traded Bond Index Prices Corporate Bond Prices Prices CDX Launched 1973 1983 1987 1999 2002 2004 2005 2013 2014 First TRACE: Bond ETF 144A Prices Wells Fargo: Electronic Trading of iTRAXX Launched in First Bond Index Fund U.S./Euro Government Europe/Asia Bonds Source: AQR. 5 AQR’s Latest Research on Fixed Income Source: AQR. 6 AQR’s Approach to Fixed Income Other Sentiment Defensive Carry Momentum Breadth Across Themes Across Breadth Portfolio Value Implementation Craftsmanship Simple Measures Complex Measures Depth Within Themes Source: AQR. For illustrative purposes only. 7 AQR’s Approach to Fixed Income Intuitive themes, systematically applied to credit and rates Theme Definition Return Drivers • Over-extrapolation Value Cheap assets outperform expensive ones • Potential compensation for systematic risk • Under-reaction to news Momentum Recent outperformers beat recent underperformers • Investor herding • Excess demand for (or supply of) capital Carry Higher yielding assets outperform lower yielding ones • Compensation due to non-profit seeking agents or for taking systematic risk • Leverage aversion Defensive Low-risk/high-quality outperforms high-risk/low quality • Lottery preferences Source: AQR. Past performance is not a guarantee of future performance. Please read important disclosures in the Appendix. 8 AQR’s Approach to Fixed Income Intuitive themes, systematically applied Theme Credit Example Rates Example EMD Example Yield relative to inflation Spread relative to default probability Spread relative to default probability Value expectations Momentum Change in spread Change in yield Change in hazard rate Carry Option-Adjusted Spread Roll-down yield Option-Adjusted Spread High credit/balance sheet quality, High credit quality, low duration High asset to debt ratio, low inflation Defensive low duration Source: AQR. Past performance is not a guarantee of future performance. Please read important disclosures in the Appendix. 9 A Systematic Approach to Fixed Income Investing Themes performed well individually, and combined they were even better Hypothetical Gross Sharpe Ratios of Simple Long/Short Portfolios Emerging Market Bonds (2004 – 2018), Government Bonds (1995 – 2017), Corporate Bonds (1997– 2017) 3.0 2.5 Global Government Bonds US Corporate Bonds Emerging Market Bonds 2.0 Sharpe Sharpe Ratio 1.5 1.0 0.5 0.0 Value Momentum Carry Defensive Composite Source: AQR, Above analysis reflects a backtest of underlying theoretical long/short themes generated by AQR definitions and is for illustrative purposes only and not based on an actual portfolio AQR manages. The composite portfolio combined the value, momentum, carry and defensive portfolios at equal weights. The results shown do not include advisory fees or transaction costs; if such fees and expenses were deducted the Sharpe ratios would be lower. The risk-free rate is the ICE BofAML US 3-Month T-Bill Index. Please read important disclosures in the Appendix for more details on construction of these portfolios. Diversification does not eliminate the risk of experiencing investment loss. Hypothetical performance results have certain inherent limitations, some of which are disclosed in the Appendix. There is no guarantee that this strategy will be successful. There is a potential for loss. Data for Emerging Market Bonds, Government Bonds, and Corporate Bonds are from January 2004 – February 2018, April 1995 – December 2017, and January 1997 – December 2017, respectively. AQR has reviewed the above research and believes that the findings are still valid even without the inclusion of more current data. 10 Where is Active Fixed Income Now? Fixed Income managers rely on credit for excess returns Core-Plus Average Outperformance vs. Global Aggregate Average Outperformance vs. HY Bond Returns HY Bond Returns Quarterly Returns 1997-2017 Quarterly Returns 1997– 2017 5% 5% Correlation: 0.95 Correlation: 0.76 4% 4% 3% 3% 2% 2% 1% 1% Plus Plus Manager - 0% 0% -1% ReturnActive -1% Active Active Return -2% -2% Average Average Core -3% ManagerAggregate GlobalAverage -3% -4% -4% -5% -5% -30% -20% -10% 0% 10% 20% 30% -30% -20% -10% 0% 10% 20% 30% ICE BofAML U.S. High Yield Index Excess Return (H0A0) ICE BofAML U.S. High Yield Index Excess Return (H0A0) Source: AQR, eVestment. Data shown is from 1/1/1997 to 6/30/2017. The Core Plus and Global Aggregate categories above are defined by eVestment. Returns used are monthly gross of fee returns of managers benchmarked to the Bloomberg Barclays US Aggregate Index (for Core Plus) and the Bloomberg Barclays Global Aggregate Index (for Global Aggregate), with USD returns, and with at least 1 year of returns for the period January 1997 through June 2017. The inception date of each manager varies. All returns are gross of fees.