There is so much talk about active versus passive, with many seeming to feel the world of investing was moving to largely passive over the last couple years, only to see active management once again gain some ground in 2017.
Passive investing, or index-based investing, is premised on the belief that markets are efficient, and prices quickly and thoroughly reflect information, thus consistently outperforming the market is difficult. Investors don’t focus on the current earnings or outlook for a company, or generally even what a company does for that matter. A passive or index-based product or vehicle will seek by replicate its underlying index by holding the same securities or a representative sample of the same securities and through that replication seek to achieve returns in line with the index. So, the argument is to just by the cheaper passive product for whatever market sector you are interested in. And this has worked over the last couple years as markets have been steadily, and seemingly indiscriminately, moving up.
But it begs the question, can decades of active investment management and numerous successful managers over this history just be an aberration or has something changed today? Our answer to both questions is no. Yes, markets have certainly gotten more efficient in their ability to disseminate and process information, which is even down to microsecond now with algorithms dictating buy and sell decisions. But if markets were completely efficient, you wouldn’t see big moves in security prices on earnings results or other news items, and in many cases the first move isn’t always the lasting one. For instance, on a weak earnings announcement or outlook, you may see a stock initially take a big move down only to recover much of that as analysts have time to process the information and the company offers further explanation via a conference call or other media appearance. Or there may have been some investors who had a thorough understanding of the business and industry and foresaw the earnings decline and sold ahead of time. Markets are two sided, you can turn on any financial news program and find two people arguing for different valuations and outlooks for a security—buyers and sellers are what create opportunities for investors and by no means do we see this as dead or a way of the past.
Additionally, many tout some market research that shows passive management as outperforming active management due to the cost of active management (generally higher fees as you are paying someone to actually do the investment work and analysis), but some of this research includes closet indexers masquerading as “active” managers, who still hold a large amount of securities like an index and only slightly deviate from an index but charge a higher fee. True active management is focused on a specific strategy or investment philosophy, has a more focused portfolio, and generally relies on analytical and/or fundamental research. Also many of the most successful active managers focus on the longer term, so there will be periods of underperformance but the goal is that the active manager will perform better over the longer term.
In the high yield bond and loan market, we especially view active management as important. The passive argument will work fine until it doesn’t, and the selling hits. We believe that what you do and, equally important, what you don’t own matters. Why blindly buy everything in an index (or virtually everything for the index products that hold a representative same), when the index does nothing to address risk other bank on the concept of diversification by holding a lot of securities. The passive products can’t avoid or sell a security in which they see outsized risks, or even where yields being generated are exceeding low for the credit profile. Active products are flexible in how they allocate money and can change their allocations given the market outlook, while the passive products can’t get defensive if the market environment warrants doing so. Passive products don’t focus on value, whereby active managers can look to buy the right securities and at the right prices.
Another deficiency that we see with many of the passive products in the high yield market is that often they have as the underlying index a sub-index of the broader high yield market index, and that sub-index eliminates a large portion of the individual high yield issues. Our own experience has been that it is often in these eliminated securities that we have historically found value. Active managers have the ability and flexibility to access an entire market, even the securities that may not be included in an index or sub-index.
With the historically high valuations that we are currently seeing in a variety of financial markets, we believe investors are turning to passive management at the wrong time, at a time when we believe active investing becomes the most important. In today’s high yield bond market we are seeing many securities trading a very low yields, in many cases around 3% and 4%, bringing down the total average yield on the index and the products that track them. Yet with an active strategy, we are able to avoid these securities or sell an existing holding if the yield gets too low. And while default rates remain low, we do see certain securities and market sectors as vulnerable, and as an active manager we have the ability to execute discretion in not investing in these securities. We believe the ability to actively position your portfolio for a certain market and economic environment is important for investors, as is looking for value, especially in a market like we are seeing today where that value is harder to find.