Indexology^® Blog

Most active managers fail most of the time, at least if we take their underperformance of passive benchmarks as evidence of failure.  The evidence of this failure is so widespread, and so consistent, that even dyed-in-the-wool active managers no longer deny it.

Instead, we often hear that the cause of unsuccessful active management is that it isn’t active enough.  Active managers, it’s said, knowing that their performance will be compared to a passive benchmark, are reluctant to deviate too much from that standard.  They therefore hold too many positions they don’t find especially attractive, simply because these stocks provide diversification and reduced tracking error relative to their benchmark index.  The proposed remedy is for active managers to use only their “best ideas,” or to invest with a greater degree of conviction.  Today’s Financial Times offered a prominent active manager a chance to argue that such “closet benchmarking” was the reason for active managers’ underperformance.

Obviously, if a manager holds 100 stocks now, and is inspired to concentrate only on his 10 “best ideas,” the new portfolio will be less index-like and less diversified than its starting point.  Is that a good thing?  Only if the manager’s a priori identification of his “best ideas” is accurate.  Why should we assume that the same manager who produces an unsuccessful 100 stock portfolio can come up with 10 outperforming ideas?

There is one point, however, on which advocates of both passive and active management can agree.  As today’s FT article put it “[F]or an individual just beginning to save for retirement…one percentage point of annual outperformance achieved by active management could translate into about 20 per cent more wealth at retirement 30 years from now, or the equivalent of more than 15 years of incremental retirement savings.”  The same one percent incremental return, however, might also be achieved, and with far higher reliability, by discarding high-fee active funds in favor of passive indices.

In a previous piece, we highlighted the emerging credit risk in Chinese corporates. Nevertheless, a recent survey reinforced the belief in the long-term future of China’s onshore bond market and pointed to an expected increase in exposure to Chinese bonds.[1]  As China’s bond market continues to grow, it may be important for market participants to identify high-quality corporate bonds.

Traditionally, market participants have used credit ratings to assess the creditworthiness of the borrower and as consistent standards so they could make comparisons across geographies and sectors. However, Chinese onshore corporate bonds are not typically rated by international rating agencies at the bond level; only selective issuer-level ratings are available.

Using the S&P China Industrials Bond Index as an example, around 30% of the bonds that the index seeks to track is rated ‘AAA’ by one of the domestic rating agencies, and among those, only 22% are rated by international rating agencies on the issuer level.  Looking at the industrial bonds that got both ‘AAA’ domestic ratings (bond level) and international ratings (issuer level), the credit quality observed varies largely; i.e., the international ratings ranges from ‘B+’/‘B1’ to ‘AA-’/‘Aa3.’  Exhibit 1 shows the range of option-adjusted spreads (OAS) across the international ratings (issuer level) for those industrial bonds, which further illustrates the broad diversity within the ‘AAA’ domestic rating band.  In comparison, while Yanzhou Coal and China Shenhua both have ‘AAA’ domestic ratings and from the energy sector, Yanzhou Coal is rated ‘BB-’ by an international rating agency (issuer level) with an OAS around 250, and China Shenhua has an international rating (issuer level) of ‘AA-’/‘Aa3’ with an OAS of 70.

In response to concern related to the discrepancies between Chinese domestic and international ratings, we launched the S&P China High Quality Corporate Bond 3-7 Year Index, which is designed to measure higher-quality corporate bonds.  In search of higher quality, we adopted a two-tier screening approach in our index design.  First, issuers must be rated investment grade by at least one of the international rating agencies, and second, securities must be rated ‘AAA’ by at least one of the local Chinese rating agencies.  Interestingly, the one-year total return of the S&P China High Quality Corporate Bond 3-7 Year Index was 6.61% as of May 16, 2016, outperforming its benchmark, the S&P China Corporate Bond Index, which returned 6.18% over the same period.

[1]   Asian Bond Investor Survey from Finance Asia, June 2016.

Exhibit 1: S&P China Industrials Bond Index–International Rating (Issuer Level) Profile for ‘AAA’ Domestic Rating (Bond Level)

The credit default swap (CDS) market is beginning to show spreads widening for consumer discretionary entities which is a bad signal for the economy.  Credit spreads between the consumer discretionary sector and high grade bonds have jumped wider in recent weeks to end last week at 84bps.  The bonds of these entities haven’t reacted too much as they closely match the performance of the high grade corporate bond market tracked by the S&P 500 Bond Index.  This could in part be driven by the demand for investment grade bonds.  Consumer discretionary equities have seen a negative 1% quarter to date return.

Table 1: Select indices and quarter to date returns:

Why watch credit default spreads?  They can be an early warning sign of trouble ahead.  As recently as mid March the spread differential between the S&P/ISDA CDS U.S. Consumer Discretionary Select 20 Index and the S&P/ISDA U.S. 150 Credit Spread Index was only 29bps.  That spread has widened to 84bps is a few short weeks.  The S&P/ISDA U.S. 150 Credit Spread Index tracks the CDS of the largest borrowers in the S&P 500 Index.

Chart 1: Select Credit Default Swap indices and their spreads:

Table 2: Constituents of the S&P/ISDA CDS U.S. Consumer Discretionary Select 20 Index:

The municipal bond market has been buffeted by pension shortfalls, Puerto Rico, Chicago, Detroit and other news worthy events.  Oil, however, is not yet one of the major forces impacting the municipal bond market.  In February 2016 oil dependent states and their municipal bonds were showing signs of weakening as the price of oil continued its plummet.  (February 2016 post can be found here) Now, nearly three months later those bonds with the exception of North Dakota have shown resilience and have performed similarly to the overall municipal bond market.

Table 1: Select municipal bond indices, their yields and total returns year-to-date:

The impact of the ECB announcement on March 10, 2016, continues to play out in the bond markets.  The governing council decided to establish a new program (the Corporate Sector Purchase Program, or CSPP), which will purchase investment-grade, euro-denominated bonds issued by non-bank corporations established in the eurozone.  The goal of the action is to further stimulate the economy.  The CSPP will be added to the existing Asset Purchase Program and will be included in the combined monthly purchases, which are to start toward the end of the second quarter of 2016.

Needless to say, this additional program has made an impact: eurozone corporate bonds, as measured by the S&P Eurozone Investment Grade Corporate Bond Index, have returned 0.39% for the month and 2.84% YTD as of May 12, 2016.  The S&P Eurozone Quasi & Foreign Government Bond Index has returned 0.59% for the month and 2.26% YTD, while the S&P Eurozone Sovereign Bond Index has returned 0.71% for the month and 2.73% YTD as of the same date.

The best-performing sector by far for the month has been financials, which makes up 60% of the index and has returned 0.20% as of the same date, though 31% are banks that do not participate in the CSPP.

Spreads of the S&P Eurozone Investment Grade Corporate Bond Index by rating category show that since mid-February 2016, the Option Adjusted Spreads (OAS) are significantly tighter for the AA, A, and BBB categories.  The BBB category has seen the most movement, tightening by 48 bps between Feb. 15, 2016, and May 11, 2016.

Exhibit-2: Eurozone Investment-Grade Corporate Bond OAS by Rating Category