…that is the question being asked by a lot of High Yield investors these days. Just as Shakespeare’s Danish prince anguished over the choices of either subjecting himself to “the slings and arrows of outrageous fortune” or attempting to drive destiny with his own actions, so investors must choose between two types of high yield funds: active or passive.
Passively managed funds, also known as Index funds, simply hold the securities or a representative sample of an index with the objective of closely replicating that index’s performance. In contrast, an actively managed fund attempts to outperform the underlying benchmark by identifying over-priced/under-priced securities and/or adjusting benchmark exposure to various risk factors, such as sector allocation, duration and beta.
Passive investors should be aware of the differences between stock and bond indices. Most equity benchmarks assign a weight to their component securities according to market capitalization, which tends to mean that the most valuable companies have the most influence on performance. Good companies become an ever larger part of such benchmarks as their equity value increases. On the other hand, bond indices weight issuers according to the amount of debt they have. Within passive funds this can create a situation of adverse selection whereby the more indebted any borrower becomes, the more exposed passive investors will be to the issuer’s credit risk. Actively managed credit funds do not need to mimic the worst tendencies of such a benchmark.
Passively managed funds are popular due to their simple, precise objectives; their inherent diversification of investments across an entire index; and because they provide investors with a tax efficient, short term beta positioning as highlighted by the relative instability of flows in the following chart.
Passive funds are offered at a low cost, but typically underperform their indexes due to fees. Moreover, fees vary across products and asset classes, and when looking closer, the fee for a high yield passive fund such as the ISHARES IBOXX USD High Yield is 50 basis points and the fee for the JP Morgan Global High Yield bond fund’s institutional share class is 45 basis points.
Active managers can pick and choose their benchmarks and therefore, define their investment universe and the risks they are exposed to more precisely. In addition, active managers can typically buy issues not in the index or load up on high conviction bonds that will potentially perform better.
Active funds can take evasive action when the market is in a downturn, but passive funds will plummet. Focusing on the high yield market and the maximum drawdown and volatility of the ISHARES IBOXX USD High Yield fund versus the JP Morgan Global High Yield bond fund returns since 2010, the below table shows that the actively managed fund offered downside protection and better performance.
In addition, the primary reason investors are compensated with substantial excess spreads to risk free rates within the high yield strategies, is the possibility of defaults. Active management is focused on minimizing the negative impact of defaults by recognizing and by avoiding deteriorating credit stories. Passive investors may experience the full effect of any default. To illustrate this point, the table below describes the default experience of the JP Morgan Global High Yield bond fund vs. its benchmark (par weighted default rate):
Passively managed funds have their merits, but as fees and performance results vary across active managers and strategies, investors should be careful in picking the right active manager who can add value over the long run.