A Place for Active Management
By Heather Rupp, CFA, Director of Communications and Research Analyst for Peritus Asset Management, Sub-Advisor of the AdvisorShares Peritus High Yield ETF (NYSE Arca: HYLD)
Be it how hedge fund returns have been struggling over the past year or how index funds have been gaining some traction, there has seemed to be much in the financial media over the past few weeks about the challenges facing active management. This certainly isn’t the first time we’ve seen people calling for the end of active management, only for those calls to be wrong.
Yes, we have seen passive strategies gain in certain sectors of the financial markets, but this only creates more opportunity for the active strategies that remain. We certainly don’t envision completely going to a model of all investments being held in index-based vehicles, or computer algorithms dictating how we allocate money. There is a place for the human element, actual people looking into a security and doing fundamental work to see if there is value, as they compile a portfolio they expect will outperform the market. We don’t believe that markets are completely efficient, nor are investors completely rational; rather, there are going to always be some dislocations and opportunities for active investors to capitalize upon, and as there are fewer people pursuing those dislocations, we would expect to see a better opportunity for gain.
Furthermore, we also believe some markets are better suited for active management than others. Yes, there are certain areas of the large-cap equity market that are VERY widely followed and where lower cost passive strategies may make more sense. However, in an area like high yield bond and loan trading, we believe this market lends itself much better to active management. Keep in mind that high yield debt trading is more complex, and it can be harder to find and source product, which can give certain managers an advantage.
Additionally, not every name is widely followed. For instance, many of the largest funds and institutional players focus more on larger issuers and the largest passive ETFs in the high yield bond market have size restrictions forcing them to primarily invest in securities over a certain tranche size, eliminating a large portion of high yield issuers. Our experience over the years has been that we have often found some of the most attractive opportunities in this sector of the market often abandoned by many. And keep in mind that if ETFs, mutual funds, insurance companies, and private funds weren’t stepping in to buy these companies that may not meet the index-criteria of certain products, there would be a large portion of the market that would not have the capital they need to run and grow their businesses.
Another area where we have seen market inefficiencies over the years is in bond ratings. Many managers and investment vehicles invest according to ratings, and the entire high yield versus investment grade market is defined by ratings. However, we believe such arbitrary restrictions limit investment opportunities. All that we need to do is look to the 2008 subprime crisis to see that the rating agencies can get it very wrong. Yet, much of the investment community still sees value in these ratings and uses them to make investment decisions—even though the agencies themselves say the ratings shouldn’t be relied upon to make investment decisions. So while some investment vehicles may limit themselves to certain ratings categories, we believe there are opportunities in certain lower rated names where the ratings agencies may have it wrong…and vice versa, the ability to avoid certain higher rated names where we believe the rating agencies have it wrong and are ignoring important risks.
Above all, we believe that high yield debt investing necessitates active management because you don’t want to be trapped in a security, owning it just because it is part of an index. We believe that the varying and dynamic risks involved in investing in the high yield asset class demand active management. And as the risk return equation changes over time, investors need to change their portfolio positioning to maximize their return, lower risk, and take advantage of opportunities. With this, not only due to their ability to invest in these often overlooked securities, but also due to their ability to be more nimble in adjusting their portfolio to changing market dynamics and opportunities as well as their ability to focus on their best ideas, we believe that smaller investment managers and vehicles, what the investment community has often termed “emerging” managers, can be better positioned in this market.
Again, we don’t believe that markets are or will ever be completely efficient nor will investors be completely rational. With the various dislocations, volatility, and opportunities we see in this market, we view the high yield debt market as one area of investing where active management will always have a place, offering investors an attractive alternative to passive vehicles. Over our years of experience in this market, we have seen over and over again where risk is mispriced, creating opportunities for potential alpha generation.