I wrote a few weeks ago about how many irrationalities and inefficiencies exist in the financial markets.  Turning specifically to the high yield market, as an active investor, we are able to exploit those inefficiencies when we find them.

First is size.  Many large institutional and fund players primarily only invest in the largest of issuers, which are often the most volatile names.  They have multi-billion dollar funds that must be filled with product.  For instance, the one of the largest index-based high yield ETFs only invests in securities with over $600mm of par outstanding.  It is the larger, well-covered by the Wall Street research desks, “on-the-run” names that people seem to pile into.  And making the same trade as everyone else, means you make the same returns as everyone else.  Through our experience, we have found that few take the time and effort to search for lesser known companies.  Yet it is in these smaller, what we like to call “one-off” names, that we have often found some of the most attractive opportunities through the years.  For instance, there are a huge number of issuers that only have $150-300mm in bonds outstanding that are great companies offering a healthy yield for investors, and we are able to include these credits in our investment universe.

Size matters and smaller portfolios have a definite advantage in the space.  Smaller managers have more ability to focus their portfolios on their best investment ideas—they don’t have to buy a whole bunch of other credits just to fill up a multi-billion dollar portfolio.  It is the smaller, what the institutional community has termed “emerging,” managers that have more ability to be nimble investors.

This also gets to the concept of diversification.  In modeling after a broad index, these index-based products end up owning hundreds of individual securities.  Yet, by the nature of active management, active portfolios are generally much more concentrated.  While we fully agree with the concept that there is a definite benefit to diversification, there is a limit to that benefit—what we call “di-worsification.”  You want to hold just enough securities to minimize your non-systemic risk.  Yet does the one-of-everything approach, used by index products, provide any extra value? We think not, as there is plenty of market research to support the notion that there are limits to diversification; you get to a point where adding more names presents no further marginal benefit in reducing risk. At the end of the day, markets are correlated and no matter how many securities you own, there is no way to avoid systemic shocks.  We have found that holding a portfolio of approximately 40-70 securities accomplishes our goals by providing sufficient diversification, yet is focused enough we are able to invest solely in the credits we see as providing the best risk/return potential.

One other area we are able to exploit is ratings.  While many other managers and investment vehicles invest according to ratings (and the entire high yield versus investment grade market is defined by ratings), we don’t impose any such arbitrary restrictions that limit our investment opportunities.  All that we need to do is look to the 2008 subprime crisis to see that the rating agencies can get it very wrong.  Yet, much of the investment community still sees value in these ratings and uses them to make investment decisions—even though the agencies themselves say the ratings shouldn’t be relied upon to make investment decisions.

We see the rating agencies as reactive, not proactive and backward looking. Yet, isn’t investing all about looking to the future?  Also, what’s the point of having ten different tiers of ratings?  Shouldn’t a credit investor just be worried about getting paid?  We don’t use ratings in making our investment decisions.   Instead, we view credit as either “AAA” or “D”: either a company will pay their interest bills and refinance at maturity (so an AAA credit) or the prospect of that happening is questionable or unlikely (so a D company).  We’ll gladly take advantage of those who blindly invest by arbitrary ratings.

We believe that smaller, niche, active managers in the high yield space, such as Peritus, truly have an advantage.  We can buy the names, big or small, that offer what we see as the best reward/return for the risk and allow us to properly position the portfolio for the market environment.  Bigger doesn’t mean better; rather, we feel it is the contrary.  We are perfectly content having the ability to be nimble and exploit market inefficiencies where they exist.