“How active is still healthy?” – A differentiated analysis for equity and credit investing

Should investors rely on passive investing or rely on active portfolio managers - for equity and credit investing?

Please note: The statements in this blog are intended to foster the exchange of individual investment experiences. All statements are the private views of the individuals who have written the respective article and are in no way related to any activities of any company. Investing involves risks. Please refer to our disclaimers.

The debate between active and passive investment funds has been ongoing for quite some time, and there is no one-size-fits-all answer as the choice depends on individual preferences, investment goals, and risk tolerances. The general opinion amongst investors is that both active and passive investment strategies have their merits, and investors often consider the following factors before making a decision:

For the question “active vs passive”, funds flow data confirm that for equity funds the race has been decided. Passive investing levels are overtaking active investments (US markets).

Assessment criteria for an “active vs passive” approach to investing.

 

Active Investment Funds:

• Active Management: Active funds are managed by professional portfolio managers who actively make decisions on buying and selling securities. They aim to outperform the market by leveraging their expertise, research, and market insights.
• Flexibility: Active managers have the flexibility to adjust the portfolio based on market conditions and take advantage of perceived opportunities or mitigate risks.
• Potential for Outperformance: The goal of active management is to generate so called “alpha” returns. Such returns surpass the returns of a benchmark index. The assumption is that skilled active managers are able to identify undervalued securities or anticipate market trends, potentially leading to better returns.
• Higher Costs: Typically, active funds have higher management fees compared to passive funds. This can erode returns, especially if the fund does not consistently outperform the market.
• Research and Expertise: Active managers conduct in-depth research and analysis to make investment decisions. Investors who prefer a hands-on approach and trust in the investment manager’s skill may opt for active funds.

Passive Investment Funds:

• Low Costs: Passive funds, such as index funds or exchange-traded funds (ETFs), aim to replicate the performance of a specific market index. As a result, they typically have lower management fees compared to active funds.
• Market Exposure: Passive funds provide broad market exposure. They are ideal for investors who believe in the long-term growth of the market and are not actively trying to beat it.
• Consistency: Since passive funds aim to replicate an index, they provide a consistent investment approach, and their performance closely tracks the benchmark index.
• Reduced Managerial Risk: Active funds depend on the skills of the portfolio manager, and if the manager makes poor investment decisions, it can negatively impact returns. Passive funds mitigate this risk as they do not rely on active decision-making.
• Lower Turnover: Passive funds typically have lower portfolio turnover compared to active funds, resulting in potentially lower transaction costs and tax implications.

Especially for equity investing the race seems to have been decided. Passive funds have long caught up with active funds and even surpassed them. Most recent fund flows confirm that this trend continued throughout 2023.

 

But what about investing in the asset class “credit”?

Do the same criteria for active vs passive investing apply for investors deciding whether to select a credit fund manager for his “alpha” or whether to buy broader and low-cost market credit index vehicles?

To answer that question, we first have to look at the definition of “alpha”. Alpha (α) of course is an investment manager’s ability to beat the market. Alpha is thus often referred to as “excess return” or the “abnormal rate of return” in relation to a benchmark, typically the broadest market index.

Now theoretical data analysis could compare managers and benchmarks but this would of course be historic data, and thus not relevant for current investment decisions.

We are more interested in a practical approach that should help Family Offices and High Net Worth Individuals (HNWIs) to make real investment decisions and therefore prefer to use indicators of future credit performance. Good indicators for alpha in credit portfolios are usually default rates and recovery rates (in combination: net loss rates). These indicators will have the most detrimental impact on investment returns. We shall focus on default rates in this paper and assume recovery rates fixed for all active and passive strategies.

Chasing the ‘alpha’ or avoiding the ‘beta’

A recent analysis by one of the global Credit Managers resulted in interesting insights when looking at what we would call the latent levels of default in the current credit markets. In order to derive relevant investment guidance for family office and HNWIs, we built on that latent default analysis and subsequently assessed how these market conclusions impact different active and passive credit investment strategies throughout a recession cycle.

Our credit universe: state of the market 2024

The researchers started by utilising a proprietary database of over 2,000 loans and bond facilities in the current market (split by US and European credit markets), which they had classified as “watchlist credits” and identified potential future default candidates, based on inhouse credit analysis. The researchers then analysed the 15,000 loans held in ca. 2,700 loan portfolios currently actively managed by over 230 CLO Managers. They checked those portfolios for exposure to the potential future default candidates and found large differences in the respective managers’ portfolios.

The research conclusions on portfolio level were as follows:

• Risk exposure for the least risky portfolios (5th percentile of the cohort) was a respectable 9% while the most risky portfolios (95% percentile) was 3x the “Watchlist” exposure or 27%.
• Portfolios of credit managers in the US market differ considerably in terms of their exposure to potential default candidates, which means that the often quoted market default rates are almost meaningless when considering risk levels in a specific credit portfolio of, say, an actively managed credit manager.

So how ‘active’ do we need to be?

We then analysed what these insights mean for investors comparing different investment strategies. Our scenarios assumed the following credit universe.

Key assumptions comparing 3 credit investing approaches (2 active vs 1 passive)

• We assume active Manager 1 (more aggressive, yield seeking) with higher fee of 1.5%, active Manager 2 (defensive credits) with lower fee of 1.0% and a passive Credit Market ETF with fees of 0.25%.
• We assume a mild recession with 1 year of credit defaults rising above the long term average of 3%.
• We assumed income generation of Managers 1 and 2 within 1 percentage point of broad market income levels. The managers’ credit selections do reflect their respective strategies, for example the aggressive style leads to higher income vs the defensive with lower income.

We can see that over a 3-year period including a 1-year recession, both active manager strategies achieve a 4% to 5% higher annual net return than the broader market, suggesting that both credit managers are generating substantial ‘alpha’. Even the conservative Manager 2 beats the market performance while holding less risk than the market.

Looking at year by year performance we can see that the most conservative manager slightly underdelivers during normal default years but outperforms by far during the downturn. The highest impact on overall 3-year performance is indeed the recession year, in which the market takes the full hit of the default spike, while managers are impacted with 9% exposure and 27% exposure respectively.

So are all the passive investors misled?

So what about the tremendous inflows into passive equity investment strategies? We think that active vs passive differs dramatically when looking at equity vs credit asset classes. Unlike equity investing, credit strategies seem to benefit significantly from manager alpha, but why?

In a way the equity investor gets paid a higher premium for the additional risk by getting unlimited upside optionality, while the credit investor rarely gets paid enough for holding the extra risk of a watchlist candidate, since in any case his investor upside is capped at 100.

Overall long term we believe that credit performance is decided in recession years and in the level of exposure to watchlist candidates. Looking at the data, the old saying that good credit managers must only manage to avoid the bottom 30% of credits and the performance will take care of itself seems to hold true once again.

We can of course expand the scenario with higher default spikes and longer recessions (2 to 3 years) which would pronounce the alpha effect of active credit managers even more.

Conclusion

We believe as portfolio managers in a family office, investing in credit with an active focus is essential for our overall portfolio targets. In our experience, finding the right fund manager makes all the difference and that’s why we do spend considerable time with our credit managers and perform intensive due diligence on single credit level before committing to a new manager or strategy.

What is your experience in active investing vs passive especially in credit related asset classes? Please leave a comment or contact us directly.

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© 2024

The Skin in the Game team