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Fixed income
28 Nov 2019 | By Huw Davies

Credit where it’s due: The case against passives

An ETF is a deeply inefficient means of accessing credit exposure, or indeed any asset class in which there is a significant divergence in credit quality.

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Here, we explore the weaknesses in such an investment approach and the benefits of investing in an actively managed fund such as the Merian Corporate Bond Fund.

Credit quality

It is rarely touched upon but there is a major assumption when investing in any passive strategy; it is assumed that all names within the defined market are the same credit risk. The weightings in ETFs are, by definition, not based on credit quality but purely on the nominal size of bond issues within the index. If you were investing in, for example, a US Treasury Government Bond index, then that is a valid assumption as the credit quality is homogeneous across the index. But in a credit index this is simply not the case.

At the heart of the philosophy that underpins the Merian Corporate Bond Fund is a belief that the key to successful long-term investment in corporate bonds is to focus on generating incremental gains, and avoiding value-destructive defaults.  

Diversification 

Another assumption when investing in passive funds is that the vehicle will match the index by investing in all of its components. This isn’t the case as passive funds attempt to replicate the performance of the index by holding its main components but retain some margin for error. Unlike in an ETF, having a wide diversification of actively managed positions has a number of advantages:

  • The liquidity of individual positions relative to the fund is higher in a well-diversified fund.

A distinctive feature of the Merian Corporate Bond Fund approach is that we seek to deliver numerous, incremental gains, rather than aiming to achieve a smaller number of more significant wins. We believe that this approach helps us to avoid the need to take unnecessary or excessive portfolio risks. 

Changing circumstances 

The portfolio of names within the Merian Corporate Bond Fund is constantly monitored, unlike those in a passive fund:

  • Merian’s investment process constantly assesses all the names in the universe.
  • If fresh information about an issuer surfaces suggesting its credit quality is deteriorating then the fund will reconsider the investment and disinvest if it considers that deterioration to be sufficiently material.
  • A passive strategy will stay allocated to a deteriorating name until the worst happens and it is no longer in the index; an actively managed fund can get out quickly.

We believe our philosophy of strenuously seeking to avoid so-called “land mines” (bonds that may offer an attractive yield, but where the vulnerability to a deterioration in corporate or economic fundamentals would increase the likelihood of the issuer being unable to meet its obligations) has made a meaningful, positive contribution to performance. In a benign environment, ETFs have little to worry about; it is in more challenging circumstances that they can have a serious problem. 

Relative value 

In an asset class where there is such a range of credit quality, there is a considerable benefit to allocating to the best relative value credits. ETFs don’t have this option; we do.

  • The means by which ETFs allocate is to buy tranches by credit rating, for example, a tranche of BBBs, a tranche for BBs etc. This means they have to buy what is available under each credit rating and that often ends up being the securities that active funds don’t want to buy. Passive funds are therefore forced into buying certain securities; we are not.

We do not believe that holding bonds from lower-rated issuers is worth the risk of permanent capital impairment in the event of a default. Conversely, we believe that a carefully managed sterling corporate bond portfolio can offer a significantly improved yield relative to gilts, as well as helping to enhance overall portfolio diversification. 

Bigger isn’t always more beautiful 

In passive equity funds, if a successful company outperforms relative to its peers its price would be expected to rise in relation to other companies, increasing its weighting in the index. In other words, an investor in an equity ETF fund would be increasingly backing the winners. By contrast, in a passive bond fund the highest allocations are to the companies running the highest level of nominal debt relative to their peers; this seems somewhat less appealing from an investors’ point of view.

 

The Merian Corporate Bond Fund is first quartile over one, three and six months, and one and three years. Its performance is ahead of its sector average – the IA Sterling Corporate Bond sector – and benchmark – the ICE BofAML Sterling Non-Gilt Index – since Lloyd Harris took on management of the fund in January 2015.[1]

% as at 31/10/19

1M

3M

6M

1Y

3Y

5Y*

Merian Corporate Bond Fund

0.2

2.0

7.1

10.5

15.3

25.9

ICE BofAML Sterling Non-Gilt Index

-0.4

1.2

5.5

9.2

13.4

29.7

IA Sterling Corporate Bond

-0.2

1.3

5.1

8.6

13.3

27.3

Quartile

1

1

1

1

1

3

* Lloyd Harris took over management of the fund on 1 December 2015.

[1] MGI 31/10/2019

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