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Why the march of passive is good for active managers
The increasing popularity of passive funds has sown fear in some areas of active management but Insight Investments Alex Veroude believes it will ultimately lead to a greater appreciation of alpha generators.
The trend towards passive bond investing is a positive for active managers as it highlights the value of the latter, says Alex Veroude, head of credit at Insight Investment (a BNY Mellon boutique).
Veroude notes that if all funds were passive then no one in the market would do the work in assessing whether a company is worthy of investing or not. For example, whether it has a good business plan and is profitable? If no one has done that work then it will lead to a collective oops moment when things go wrong. So if youre an active manager in that environment, having done the analysis and avoiding the oops moment, then you have added quite a bit of value. Active managers clearly have a reason to say active management is best but I do think there is some truth in the statement.
Today there is limited opportunity for active managers to prove their worth, especially as they contend with the aftermath of central bank interventions. According to Insight, since 2011, central bank monetary easing actions and quantitative easing (QE) programmes have helped sustain a virtuous cycle in credit. The expansion of central bank balance sheets has driven down yields on government bonds, which crowded out other investors and incentivised them to purchase riskier assets to earn reasonable yields, driving demand for investment grade and high yield credit, Insights credit team explains.
This demand led to a wave of credit spread tightening in those markets. In turn this led to portfolio gains, which in turn led to improved risk appetite and lower implied defaults. This then led to further tightening and the cycle coming full circle, repeating itself until credit spreads reached post-global financial crisis lows in 2013. However, no cycle exists in a vacuum impervious to external forces and a virtuous cycle can always at some point turn vicious. In the second half of 2015 and the start of 2016, this became a threat, explains Veroude.
Threats to sentiment present particularly grave concerns given the pro-cyclical nature of credit spreads, he adds. Veroude goes on to note that while significant credit spread tightening tends to inspire further tightening the reverse can also be true. Higher spreads can lead to losses, reduced risk appetite, higher implied defaults, downgrades and then more losses. Such a vicious cycle could be damaging to credit investors.
The expansion of the European Central Banks (ECB) QE programme beyond government bonds represents a strategic shift but for policymakers, agreeing the full scope of eligible assets may prove difficult. Veroude points out that central bank intervention in this area is tricky as there are political and commercial ramifications to their decisions. For example, he says, if the ECB buys the corporate debt of a company that subsequently goes bust the bank could be in a position to fire employees in a certain country; or if a central bank buys the debt of one supermarket over another, it could be providing a capital advantage to one competitor and not the other.
In the short term, fears of a sustained rise in credit spreads appear to have been allayed. However, Insight notes fundamentals and the business cycle may reassert their influence.
As such, Veroude believes focusing on the key metrics of fundamental credit analysis will be more important when navigating the next stage of the credit cycle than trying to second-guess the actions of central banks. And in doing this he thinks active bond managers can truly show their worth.
