Some Credit for Active Management

Tempted by high yield? Here’s why we think investors may want to consider resisting the temptation to invest passively.

Today’s CIO Weekly Perspectives comes from guest contributors Chris Kocinski, Joseph Lind and Simon Matthews.

As consensus grows that U.S., eurozone and U.K. policy rates are at or near their cycle peaks, we anticipate more focus on fixed income in asset allocations next year as investors seek to lock in yields.

Given the generally improved trends in corporate borrowing over recent years, we think high yield bonds deserve serious attention—including the higher quality euro high yield market. At the same time, one reason many investors think rates are peaking is that they also think the global economy is heading into a slowdown next year.

That is likely to lead to a rise in credit stress and defaults, which, though potentially meaningful, we expect to be idiosyncratic rather than systemic. That is why we think investors interested in high yield should think twice about accessing this market via an exchange-traded fund (ETF) or other passive product.

Active high yield managers can choose to be “long the strong” and try to avoid issuers with clear challenges ahead, a simple but crucial advantage as defaults begin to rise. Moreover, this is not the only advantage they have—and the result is an active-passive debate framed very differently from the one we are used to in equities.

Impact

We believe active credit managers have a strategic advantage and a cost advantage.

The strategic advantage is about risk management.

A passive equity strategy exhibits price momentum: The biggest companies in the portfolio are those that have performed best in the past. That can be a problem if the strategy becomes overexposed to companies with high valuations, but, in general, a company is rewarded with a higher valuation because investors think it is a quality business.

By contrast, the biggest companies in a passive bond portfolio are those that have issued the most debt. That doesn’t mean they are the most leveraged or the most likely to get into difficulty, but high debt issuance tends to be less positive than a high equity market capitalization.

Furthermore, companies in difficulty often have a bigger impact in a bond portfolio than in an equity portfolio. If an equity drops by 20% for idiosyncratic reasons, gains from other stocks in the portfolio are more likely to counterbalance the loss than in a credit portfolio. The upside for equity is essentially unlimited, whereas a bond’s upside, even for the best issuers, is limited to the coupon plus the potential for a small amount of capital appreciation.

For that reason, while diversification is important in a bond portfolio, we think it’s critical not to assume that it removes the need for credit analysis and selection.

Fragmented and Less Liquid

The cost advantage that active managers have derives from the nature of the market.

Companies tend to issue new equity infrequently, and when they do, the new equity is usually indistinguishable from the existing equity. That makes equity indices relatively stable, setting aside the companies that exit and enter them during regular constituent reviews.

Bond indices also undergo those reviews, but companies frequently issue new debt, and each new issue is distinct from the last, with potentially different coupons, maturity dates and other terms. That makes replicating the bond market more complex than replicating the equity market, and replicating the index with a passive investment strategy more complex still.

The result is more trading in a passive high yield portfolio than one would expect in a passive equity portfolio—despite the high yield bond market being substantially more fragmented and less liquid than most equity markets.

That can mean relatively high trading costs (which, by the way, are not covered by an ETF’s published Total Expense Ratio), but it is also an incentive for index portfolio managers to try to track their benchmarks while avoiding some of the smaller, less-liquid bond issues. In contrast, active managers, who do not need to trade as much, are able to hold these bonds and benefit from the premium they tend to offer.

Performance

We think these strategic and cost advantages help explain why active high yield bond managers tend to stack up better than active equity managers against their passive equivalents.

Investors are used to hearing the claim that the performance of the average active equity manager is likely to be roughly the same as that of the benchmark index minus the difference in fees. But in high yield, the net-of-fees total return of even the average active manager is often higher than that of the passive strategies. (We recently published a paper showing this outperformance for the European high yield universe, using Morningstar performance data.)

We believe these are persuasive reasons for choosing active over passive high yield bond management at any time. With interest rates back at pre-2008 levels, credit-spread dispersion widening and idiosyncratic credit issues on the rise, that choice could be especially important for investment outcomes over the weeks and months ahead.