Active Management: How active management can take advantage of passive instruments in the credit markets
Credit markets are in a state of transition, with passive instruments such as ETF’s having become major parts of the investing landscape in recent years. Within this context, an active manager faces some challenges but can also be positioned to take advantage of key limitations of these large and passive instruments.
“A lot of credit managers are simply in denial regarding the growing presence of ETF’s in their market,” says Pender Corporate Bond Fund Manager, Geoff Castle. “However these instruments are here to stay. The good news is that if you study both the composition and the behaviour of ETF’s in credit markets, you will find some very interesting ways to exploit them.”
Formula driven trades
Those opportunities are often driven by various pre-established buy and sell rules that exchange traded funds must conform to in order to track underlying indices. In periodic rebalancing trades, all exchange traded funds sell and buy blocks of securities in order to bring their portfolio into line with the index they are intended to mimic. In normal markets these rebalancing events have minimal effect, but in markets that are either stressed or euphoric, index rebalances can create extraordinary openings for the active manager participating in the same field as an ETF.
One example of an opportunity that the Pender Corporate Bond Fund was able to exploit concerned the exclusion in early February, 2016, of the second lien 11% bonds of Gulf of Mexico oil producer, Energy XXI from a high profile exchange traded fund.
“We saw one ETF selling off its entire holding in Energy XXI. It was a trade based entirely on an index deletion, without the slightest regard for the value of the underlying assets that these bonds had a claim on,” noted Castle. “Our fundamental analysis told us that, although this company was close to filing for bankruptcy, based on the collateral these bonds represented, they were significantly undervalued. We bought the ETF block for 11c on the dollar and the price of these bonds is now more than three times our cost, currently trading around 40c on the dollar, post-reorganization.”
Security specific trades
ETF’s that focus on relatively small or illiquid underlying markets also create unique investment situations. Pender’s portfolio management team closely follows the activity of ETF’s in the Canadian preferred share market and regularly identifies opportunities from the forced buying or selling by the passive instruments in this market.
“One of the things we have noticed in the ‘pref’ share market is an increase in the issuance activity by Canadian banks over the last six months. This has led to large block trades of more attractively priced preferreds out of the ETF’s.” said Castle. “Even though the existing ‘pref’ shares are trading at higher yields and have large discounts to par value, the index tracking ETF’s have no choice but to sell some of the best securities in the index in order to make room for the new bank ‘pref’ shares that have lower return potential and lower credit quality due their equitizable nature.”
Whether it is ETF’s today or another instrument tomorrow, the world of investing is not going to stand still and the drive to create new instruments is never ending. There will always be opportunities to exploit loopholes that arise from structured products and ETF’s. For the active manager, understanding the potential shortcomings of the various instruments available to investors gives you an informational edge which can be leveraged by unconstrained funds.
“We believe the more tightly you define a fund the less likely it is to deliver attractive absolute returns in the long run. If we see an area of the market become unattractive, we can just avoid it,” says Castle. “Credit ETF investors, particularly those funds that track a very small segment of the overall credit market, run the risk of being linked to a very unattractive sub-index if they intend to hold long-term.”
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