Ok, so maybe not. No one really believes this, do they? We would venture to guess that no one reading this has ever uttered these words – not out loud anyway. Perhaps few even among the broader investor community would be so brash. But how else are we to interpret the overwhelming bias toward indexed portfolios that has dominated the markets in the last decade? How else do you explain $7BN into high yield within a week at the beginning of April? How else do you explain the 1%+ performance gaps between fixed income ETFs and the indices they track?
Let’s start with the simple observation that if an investor chooses to invest in an index fund, it is likely for one of two reasons: Either the fund is a long-term hold based on the belief that short-term fluctuations can be disregarded; or the fund is a tactical bet on shorter-term gains in a particular asset class with the expectation of exiting the investment before that asset class declines or as soon as it begins to do so. How’d that work out?
But therein lies the problem. Passive index investments must be part of an active investment strategy if the goal is to avoid the potentially large losses that come with a market correction. 1 And while rational hindsight may argue that markets eventually recover, most investors are not quite so rational in the thick of a decline, nor is there any visibility into how long the recovery will take – otherwise, they wouldn’t be selling on the way down and creating the volatility in the first place! The many retirees that found themselves back in the workforce in 2009 can attest to the material difference between theory and practice in this respect. In today’s market, it is too soon to tell what the long- term fallout might be or where we are in the recovery cycle. But we’re fairly confident that (a) this is just the beginning of a long story and (b) we won’t be able to pretend none of this happened.
With ETFs multiplying like rabbits, we now have passive vehicles for every manner of asset class, including many that track such instruments as syndicated bank loans and broad market high yield bonds. We at Zeo obviously invest in these asset classes, and we find the idea of ETFs tracking these particular markets curious to say the least. The underlying instruments do not lend themselves to indexing or to the scale required to support a capacity-unconstrained ETF structure for a few reasons. First, these asset classes are traded over-the-counter (as opposed to on an exchange), and there is significant friction to tracking an index. We saw just that in March when trading costs and supply/ demand imbalances created large variances in performance between indices and the ETFs that aim to track them. Second, to satisfy the scale and diversification requirements of an ETF, a fund must compromise on credit quality, in a credit-focused investment no less. And third, these asset classes do not represent broad market economic indicators, which relegates them primarily to tactical usage and eliminates the “next marginal buyer” support that often mitigates volatility.
Let’s dive into this last point a bit more. A “next marginal buyer” effect depends on the existence of multiple groups of investors in the same asset class with different investment theses. Each thesis may cause that investor to enter or exit the market at different times and different prices, but typically, the exit prices for one investor group will be the same as the entry prices for another investor group. The result of this is a “win-win”, not unlike when a company buys a business for strategic reasons (e.g. to capitalize on synergies) from a current owner who originally purchased it for financial reasons (e.g. a private equity sponsor) – the business is worth more to the corporate buyer than to the private equity owner.
But when one investment thesis dominates an asset class, as is the case with the presumed Federal Reserve credit intervention at the moment, prices can get inflated when that investor group begins buying and selling to itself or buys largely from primary rather than secondary market participants. Buyers pay higher prices to take the other side of sellers who no longer believe in their shared thesis or to buy securities directly from an issuer who won’t provide a bid if the market declines thereafter. But we are missing a buyer in the secondary market with a different thesis (e.g. non-tactical) to backstop the last investor standing when the music stops. Or, more accurately, that “next marginal buyer” exists but has an entry price that is at a significant discount to where the current market is trading. Once the exit begins, look out below.
This happened in 2008 to the convertible bond market when hedge funds inflated the prices of convertibles using leverage and increasingly-complicated derivative valuation models. When these funds all looked to the exits, they found that the next marginal buyer was the fundamental credit investor, who set the exit price so far below current levels that the entire convertible market ended up in a vicious cycle of margin calls and asset price declines.
In today’s market, we are starting to see inklings of similar dynamics in investment grade fixed income, where tactical investors are betting on the Federal Reserve to prop up asset prices while the next marginal buyers, fundamental investors, are pointing to over leveraged companies and looming wide scale credit downgrades. Index investors may want to take note of where those buyers are actually willing to take those BBB bonds off their hands when the Fed-based thesis dries up. This is not to say that bank loans, corporate bonds or other similar markets are not worth investing in. On the contrary, we believe, on a selective basis, they present some of the best opportunities as we look forward, especially credit-oriented markets such as high yield, where we see some of the best risk/ rewards for individual security selection. But such strategies are typically fundamental in nature, with managers careful about the types of risks they take within these asset classes. These strategies are typically capacity-constrained as a result, focused mainly on that subset of the investments for which there are marginal buyers. And these strategies are often miscategorized because their risk profile, their asset class and their return profile each seem to fit a different category.
What does it mean to be the fundamental investor in a market full of timers? It’s viewing the purchase (or sale) of corporate credit not as a tactical trading decision based on whether an entire asset class will go up (or down). Instead, it’s viewing investments for what they are: Each position represents lending to an individual company and evaluating whether that company will pay their debts.
As such, a fundamental strategy thesis is completely different from the passive strategy. It is not our goal to change the mind of the indexed ETF evangelist who has great confidence in his ability to time the market. We wish him well in his effort. But when he comes to sell, we will be ready and waiting as the next marginal buyer to provide him the liquidity he needs...at our price. Just as we were in March.
1 “Not true!”, said the passive indexer, right before he made an active decision to shift passive index exposures.
Important Disclosure Information
Zeo Capital Advisors is a fundamental investment manager with a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk Reddy authored this piece and is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.
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