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Paul Keeton, Dorsey Wright

Using relative strength to harvest alpha in fixed income ETFs

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Dorsey, Wright & Associates, a Nasdaq company, whose expertise in technical analysis helps bring innovative investment solutions to Wall Street, has developed a new ‘smart beta’ fixed income index designed to operate in a non-traditional fashion. 

Referred to as the Dorsey Wright Fixed Income Allocation Indexthe ETF-linked index uses relative strength (a momentum factor investing technique) to compare and rank the best performing SPDR-related fixed income ETFs out of a total universe of 20 ETFs comprised of: floating rate notes; first lien senior secured floating rate bank loans; US non-convertibles; preferred stock and other preferred securities; US municipal bonds and US convertible securities; US and non-US developed and emerging market bonds; treasury bonds; corporate bonds; high yield bonds, and inflation protected bonds. 

At any given time, the Index holds four ETFs from the SPDR product line that display the most powerful relative strength characteristics. Every week, the Dorsey Wright team evaluates the Index using what is known as ‘Point & Figure’ charting; an organised way of recording supply and demand within a security by focusing purely on the price movements of that security. 

“The Index has at its disposal more than 20 different bond sub-sectors. It can go from being very sensitive to US 10-year rates to very insensitive to US 10-year rates and is designed to follow market driven trends, where traditional fixed income indexes cannot. At a time when the consensus market outlook is for low returns within traditional fixed income, the Index presents an opportunity to chase alpha that exists in some of the lesser-used areas of the bond market,” explains Paul Keeton (pictured), Vice President at Dorsey, Wright & Associates. 

The Index uses a modified equal weight strategy. Given that it holds four ETFs at any given time, each has a 25 per cent weighting. These will float based on market movement between rebalances.

Dispersion Characteristics

Within the Index universe the idea is to hold fixed income ETFs that display a range of dispersion characteristics. A long duration Treasury bond ETF, for example, is designed to have a strong inverse correlation to 10-year rates whereas an emerging market bond ETF, or a US preferred stock ETF will have close to zero correlation (0.08 over the last five years according to Keeton). 

“There are enough component parts within the inventory for the Index that has no real correlation to interest rates and this allows the Index to behave differently than traditional fixed income indexes. 

“As of today, there are more than 20 securities that in our view all offer different return profiles in different areas of the bond market. Three years from now, as new areas are tapped into, the index inventory might grow. Equally, if, for whatever reason, the bond market becomes less liquid, the inventory might shrink. The bottom line is that every component has to be additive to the overall capabilities of the Index,” explains Keeton.

By additive, what Keeton means is that the first step in building an index inventory is to select securities that are proven in the marketplace and that have proven resilient during stress events. If the Index contained a 12-year Treasury fund, a 13-year Treasury fund and a 14-year Treasury fund, this would not be additive at all because they would all largely behave the same and move the same for roughly the same reasons.

“All you’ve really done is add concentration risk. You’ve now got three components in the Index that could all behave the same and could all, in theory, be held within the Index. We have to avoid that. We’re not trying to build an index that behaves like a long term Treasury fund. We want an index that behaves different than traditional fixed income instruments and we attempt to do that, using relative strength, to carefully build an inventory of things that disperse,” says Keeton. 

He confirms that since the Index went live in February there have been three changes in the overall composition of the Index, based on weekly appraisals. 

“Currently, the Index is slightly less sensitive to US interest rates. Roughly 50 per cent of the Index is holding international bond positions,” adds Keeton.

The four ETFs comprising the Index, as of today, include: SPDR Barclays International Treasury Bond ETF (NYSEArca: BWX); SPDR Barclays Emerging Markets Local Bond ETF (NYSEArca: EBND); SPDR Wells Fargo Preferred Stock ETF (NYSEArca: PSK) and SPDR Nuveen Barclays Municipal Bond ETF (NYSEArca: TFI). 

Relative Strength Methodology

Dorsey Wright specializes in relative strength as an investment methodology and has been applying it to other areas of the market outside of the domestic equity asset class. Indeed, within equities, the Dorsey Wright Focus Five Index uses a similar approach to that of the Dorsey Wright Fixed Income Allocation Index, selecting five exchange-traded funds from the First Trust Portfolios product line with the strongest relative strength characteristics. 

“That Index also has a weekly evaluation and covers an inventory of about 20 First Trust equity ETFs, and we rank those securities top to bottom using relative strength. We own the things at the top and if something falls, it gets kicked out and replaced with something else. 

“That same ranking process is applied to fixed income. State Street’s product line up gives us ample exposure to the fixed income space. Ultimately, our goal is to build world-class investment solutions and work with world-class partners to make them as accessible as possible to the global investor community,” comments Keeton.

Relative strength is designed to benefit from the dispersion that exists within an asset class. Within a fixed income context, Emerging Market bonds are going to behave differently than US Treasuries and high yield is going to behave very differently than investment grade corporates. That dispersion, says Keeton, is what allows relative strength to work: “There needs to be divergence of trends from the investment inventory for this methodology to add value.” 

“Relative strength is based on identifying emerging leadership in the market, participating in it and having a timely process for identifying the end of that leadership trend. By doing that repeatedly over time, we believe the index will deliver a better end result when it comes to navigating global fixed income.”

Within State Street’s SPDR fixed income ETF line up, there exists a wide range of sensitivities to rates from strongly inversely correlated through to non-correlated. That allows for a lot of dispersion within the inventory over time. 

“We have selected the inventory carefully to ensure there is exposure to all of the liquid aspects of the US bond market. Each week we rank the inventory so that only the four ETFs that exhibit the strongest relative strength are included. This allows the Index to adapt over time,” explains Keeton.

Leading edge not bleeding edge 

Timing is critical when it comes to developing a smart beta index, especially within fixed income. 

Launching the Dorsey Wright Fixed Income Allocation Index five or ten years ago would not have been as attractive, as there simply were not as many proven ETFs that provided access to things like floating rate bonds, or US convertible bonds.   

Now that the universe has matured, thanks to State Street and other ETF sponsors, it has allowed index creators like Nasdaq and Dorsey Wright to leverage relative strength to create non-traditional fixed income indexes. And, hopefully, extract more of the potential alpha that is available through the various fixed income elements in indexes such as that developed by Dorsey Wright. 

“Whenever we create a new index we have to be confident that it adds demonstrable value with the potential to extract a better investment outcome from the particular base inventory. 

“Relative strength is a robust return factor, and I’m sure we’ll discover more index creation opportunities as other markets further evolve,” concludes Keeton. 

For more information, download the Nasdaq/Dorsey Wright white paper on Relative Strength here or contact them here.

 


Dorsey, Wright calculates correlation (rate sensitivity) based upon 5 years of weekly return data of underlying securities or indices, compared to returns over the same period of the US 10-year Treasury Yield Index. Neither the information within this email, nor any opinion expressed shall constitute an offer to sell or a solicitation or an offer to buy any securities, commodities or exchange traded products.  This article does not purport to be complete description of the securities or commodities, markets or developments to which reference is made. This article not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. Before acting on any analysis, advice or recommendation (express or implied) in this article, clients should consider whether the security or strategy in question is suitable for their particular circumstances and, if necessary, seek professional advice. The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.  Relative Strength is a measure of price momentum based on historical price activity.  Relative Strength is not predictive and there is no assurance that forecasts based on relative strength can be relied upon.

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