Early research on the Capital Asset Pricing Model (CAPM) suggested that the only relevant source of risk premium in the economy was the world market portfolio. However, subsequent multi-factor models such as the Arbitrage Pricing Theory (APT) demonstrated that there were potentially many sources of risk and that a limited number of factors could explain the returns of a well-diversified portfolio. Following the work of Fama and French (1992) and Carhart (1997), factor-based investing approaches grew in popularity most notably within the equity industry where the idea of capturing factors such as momentum, value, quality or size ignited the creation of various "smart beta" products that offered alternative construction rules to traditional market-capitalization weighted indices. Over the last few years, the concept of factor-based investing has continued to set roots across asset classes and has become the foundation to many alternative investment approaches globally.
Institutional investors are now increasingly turning to risk-based portfolio construction techniques seeking to achieve desired investment outcomes. Aligning exposures towards alternative risk factors can unlock new sources of risk premium that can generate long-term returns while exhibiting low and stable correlations against traditional assets. We posit that a factor-based investing approach can be used effectively within fixed income portfolios to improve returns, reduce risk, or both. As an added benefit, obtaining exposure to risk factors through investable, systematic, rules-based derivative strategies can further enhance market capacity, liquidity and rebalancing agility for large asset owners.