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Passive resistance

Standard Life Investments head of UK wholesale Jacquie Kerr discusses why a passive approach to investment can be less likely to meet an investor’s goals

ETF and tracker funds may often seem like the easy option but we do not believe that all the risks attached to investing in trackers and ETFs are fully understood. A number of myths need to be dispelled and someone needs to say that the emperor has no clothes.

ETFs are not always cheap, they don’t always do what they say on the tin and they need to be analysed closely in order to fully understand all the tax implications and risks attached.

We believe the best way to meet the return objectives and risk attitude of investors is through an active investment approach. We believe the shortcomings of the efficient market hypothesis mean there are nearly always mispricing opportunities in markets.

By implementing a robust and repeatable investment process, we believe it is possible to exploit these irregularities and deliver strong and sustained abovemarket returns.

This is not to say that passive funds do not have a role to play in tailoring a portfolio to meet investor needs. However, there is a misconception from some investors that passive funds deliver market-like returns while neutralising market risk.

It is important to remember that although indices are sometimes used as proxies for passive fund performance, these indicators have no expenses and cannot be owned.

Crucially, the credit rating agencies’ focus is different to the concerns of investors. While agencies are assessing the likelihood that a company will default on its debt, investors are concerned with a fall in value of their investment

Passive funds, on the other hand, are much more complicated investment vehicles, with their own risk considerations. In certain asset classes, the case for good active management is even more compelling. Take corporate bonds for example. In addition to the standard arguments against passive management, there are further factors which make the approach less appropriate in corporate bond markets.

In debt markets, an issuer’s “weight” is not determined by how successful the underlying company is but by how much outstanding debt they have. As such, passive bond funds effectively oblige investors to own the most indebted issuers.

This feels wrong intuitively. In addition, in equity markets, as a company grows, it gains more weight in the market. Such positive momentum does not exist in corp-orate bond markets.

Passive funds cannot avoid defaults. In 2008, 104 corporate issuers defaulted on over $240bn of debt. Lehman Brothers was among the most high profile of these, defaulting on $120bn of their debt. As active managers, we were not exposed, however, Lehman Bros bonds appeared in several high-profile corporate bond indices, including the Merrill Lynch Euro corporate index, where Lehman bonds comprised around 0.55 per cent.

The composition of corporate bond market indices is often a function of the credit ratings of the underlying securities. For example, high-level corporate bond indices will comprise investment-grade or high-yield bonds as well as there being indices which are specific to bonds of a particular rating.

Crucially, the credit rating agencies’ focus is different to the concerns of investors. While agencies are assessing the likelihood that a company will default on its debt, investors are concerned with a fall in value of their investment.

Changes to credit ratings may lead to bonds moving in and out of particular indices. This will require “forced” buying or selling by passive corporate bond funds. In distressed market conditions, this could be particularly painful or, during periods of no liquidity, virtually impossible.

An additional concern for an active corporate bond manager is duration – the sensitivity of a bond, or a portfolio of bonds, to changes in interest rates. When interest rates are absolutely high, bonds will be issued with higher coupons (that is, shorter duration). This means that passive investors, following the market, will effectively shorten duration at a time when an active manager may well be looking to lengthen his in anticipation of interest rates moving lower.

Bonds are usually issued with a fixed maturity date and a fixed coupon. Companies will issue different tranches of bonds with different characteristics to meet their own liquidity requirements and/or to attract buyers. This means there is a high degree of turnover in corporate bond markets as bonds mature and new issues enter the market which translates to regular changes to market index compositions. This, in turn, will require increased rebalancing activity by a passively managed corporate bond fund which translates to higher transactional costs which can dilute the overall performance of the fund.

With individual companies often having several bonds in issue at any one time, corporate bond market indices can comprise a big number of securities.

In addition, some bonds are issued in relatively small lot sizes making for lower liquidity/thin trading conditions. Such factors will make full replication particularly challenging.

As an active fund manager, we obviously stand on the side of active management in the great active versus passive debate. However, as demonstrated above, there are factors which make a passive approach to investment particularly inappropriate and less likely to achieve the individual requirements of investors.


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