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Three reasons for staying active in high-yield
VIEWPOINT – Managing directors Craig Abouchar and Thomas McDonnell at Barings give three reasons why investors should consider an active approach in the high-yield bond and senior secured loan markets.
Craig Abouchar and Thomas McDonnell 29 Jun 2017

The often-touted fact that the average active manager routinely underperforms the index has encouraged investors to embrace passive investing over the last decade. In many asset classes, like large-cap US equities, this has proven to be a lucrative strategy. Investors gain exposure to an underlying asset class while incurring much lower costs. The problem, of course, is that this one-size-fits-all passive investment strategy does not work equally well across all asset classes.

Fixed income markets are a good case in point, particularly the high-yield bond and senior secured loan markets. For a variety of reasons, three of which we set out below, these markets are less efficient, meaning that nimble, active management tends to result in excess returns for investors, above and beyond what passive strategies have been able to achieve. Here are three reasons why investors may want to consider an active approach to these markets:

1. Replicating some indexes can be hard – even impossible
Successful passive management is based on the premise that the relevant asset class index can be accurately replicated. It’s one thing to mirror, for instance, the S&P 500 in a passive strategy; it’s a completely different undertaking – and in many cases an impossible one – to get exposure to every constituent of the major high-yield bond and loan indexes, at least in a cost-efficient manner. As a result, high-yield exchange-traded funds – a good proxy for passive investing in the space – tend to focus only on the large, liquid issuers in the index. However, big and liquid isn’t necessarily always best in high-yield investing. Unlike equities, where a company’s size might be taken as an indicator of its historical performance, issuer size in the high-yield market has the potential to mean quite the opposite, i.e., a company weighed down by too much debt.

So, not only are large, passive high-yield ETFs not investing in the full high-yield universe – they are not necessarily investing in the best of the rest, potentially because of their “large and liquid” bias.

2. Volatile flows and headline events hinder passive ETFs’ trading
Unlike an active manager, passive ETFs don’t have discretion on when to invest: they must buy when there are inflows and sell when there are outflows. Also, compared with active funds, their flows can be erratic because of the short-term focus of many of their investors, and because macro headlines, not fundamentals, often drive retail investor flows. As a result, ETFs can be forced-buyers and forced-sellers of assets – with the large ETF funds often moving in the same direction, at the same time, chasing the same diminished universe of high-yield credits on the upside, and trying to sell the same names on the downside.

That obviously doesn’t bode well for passive ETFs achieving best execution on their trades, but it can be a silver lining for active high-yield managers. Active managers can sell strong-performing bonds and loans and move into credits that are still judged to be fundamentally sound, but down purely because of a technical sell-off. Furthermore, the rules-based nature of passive ETF investing and the transparency of their holdings can help an active manager identify such opportunities – so that when the right opportunity presents itself, they can be (and often are) ready and waiting to take the other side of an ETF’s forced trade.

3. Passive high-yield strategies have consistently missed the performance mark
The final nail in high-yield’s passive coffin is the fact that high-yield ETFs have routinely and significantly underperformed the high-yield index and active managers.

While the reasons already enumerated are factors in this underperformance, so is high-yield’s very different return symmetry to equities, which have proved more fruitful ground for passive investing. Fixed income’s more limited capital appreciation potential means investors stand to lose significantly more than they may gain on any given bond – so avoiding losers is critical for success. However, that’s harder for ETFs to do, since their investment decisions are flow- and rules-based as opposed to value-based. Active managers of high-yield, on the other hand, are not restricted to any reduced “list” of issuers, and can exercise greater flexibility on when to trade.

Craig Abouchar, CFA, is managing director, European high-yield, at Barings. Thomas McDonnell is managing director, US high-yield, at Barings.

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