Is Your Manager Nimble? Why Size Matters in Investment Grade Credit Bigger is not necessarily better in the fixed income market. Smaller investment managers are demonstrating their ability to consistently and meaningfully express investment views as they seek to generate alpha. April 2016
Given the sheer size of the largest fixed income bond managers, even the most diversified have to trade significant volumes of a single bond when their investment views change. The industry has witnessed a shift handing a great advantage to smaller, more nimble managers who trade more tractable dollar amounts. When it comes to fixed income investing, is bigger better? We think the more important question is: How nimble is your manager? In the US investment grade credit market, managers with fewer assets under management have greater potential to generate alpha, and can move more effectively in and out of positions in markets where liquidity has dried up. Why? Nimble managers can do more. They can be selective, targeting specific exposures on the credit curve or individual securities in a capital structure. Nimble managers also have a wealth of opportunities to differentiate themselves from the index within index bonds. Finally, nimble managers have a key advantage in risk management: It s easier for them to exit positions as trading becomes strained in the secondary markets. Size has its disadvantages. Larger managers have to buy bonds across a curve, and across a capital structure. They can end up looking a lot like the index. To generate alpha, many mega managers have had to reach outside the realm of investment grade credit to generate alpha. It s also much harder for them to exit positions given the sheer size of their holdings. Our analysis shows that managers advising fixed income assets under US$20 billion may be better positioned to express their views and therefore add alpha than managers over US$20 billion due to the dynamics of the market. We analyzed managers between a US$2 billion and US$20 billion threshold, which we define as nimble, and believe they are more favorably positioned to add alpha. Robert Vanden Assem, CFA Managing Director, Head of Developed Markets Investment Grade Credit PineBridge Investments, New York Vladimir Karlov Managing Director, Head of Quantitative Portfolio Management PineBridge Investments, New York The big squeeze One of the results of the global financial crisis was an increase in regulation to limit banks ability to take excessive or unwarranted risks. Specifically, regulations such as the Volker Rule and Basel III capital requirements have curbed the ability and willingness of banks to hold large inventories of corporate debt on their balance sheets. As a result, post-crisis dealer inventories are lower even though debt issuance has increased substantially. Accordingly, the dollar amount of debt held by large investors like insurance companies and exchange traded funds has increased as the amount held by broker-dealers has decreased. This has heightened volatility and squeezed liquidity, and has fundamentally shifted the market dynamics. Moving larger blocks of bonds is more difficult today. 2 PINEBRIDGE INVESTMENTS
$6,000 $5,000 Barclays US Credit Index - Market Value (left axis) $300 $250 US Dollar Billions $4,000 $3,000 $2,000 Broker-Dealer Inventory (right axis) $200 $150 $100 US Dollar Billions Shifting dynamics: credit markets continue to expand while dealer inventory continues to decline $1,000 $50 $0 $0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Source: Federal Reserve, Barclays, JPMorgan and PineBridge Investments. As of 31 December 2015. Measuring performance For investors, the key question is whether falling inventory and tighter liquidity are affecting performance. We analyzed the US investment grade credit peer group (as measured by evestment Alliance) and divided it into three subsets of managers. We selected their 2012 maximum assets under management (AUM) as the starting point to narrow the universe to managers who survived the financial crisis in order to determine which subset performed best, on average, over intermediate time periods as a way to gauge the success of a manager s strategy relative to its peers. From an alpha perspective, nimble managers outpaced their small and mega counterparts over three and five years versus the Barclays US Credit Index. WHY SIZE MATTERS IN INVESTMENT GRADE CREDIT 3
Our analysis groups US investment grade credit managers as follows: Mega managers: US$20 billion or more Nimble managers: Between US$2 billion and US$20 billion Small managers: Under US$2 billion Rolling Three-Year Alpha Versus Barclays US Credit Index 1 Mega Manager (>US $20Bn) Nimble Manager (US$20Bn-$2Bn) Small Manager (<US$2Bn) 3 Yrs 5 Yrs 3 Yrs 5 Yrs 3 Yrs 5 Yrs 5th Percentile 3.02% 3.66% 4.16% 5.48% 3.67% 3.52% 25th Percentile 2.28% 2.60% 2.91% 4.15% 2.12% 2.64% Median 1.50% 2.22% 1.66% 2.40% 1.53% 1.39% 75th Percentile 1.08% 1.37% 1.34% 1.67% 0.84% 1.03% 95th Percentile 0.97% 0.86% 0.85% 1.16% 0.18% 0.59% 1 Source: evestment Alliance. As of 31 December 2015. Universe Construction Methodology: evestment US Corporate Fixed Income universe was screened to only include strategies that have listed the Barclays US Credit Index or Barclays US Corporate Investment Grade Index as the preferred benchmark. Peer groups were further segregated based on year-end 2012 AUM. The small managers were those strategies whose year-end 2012 AUM was $2 billion or less. Nimble managers were those strategies whose year-end 2012 AUM was greater than $2 billion and less than $20 billion. Mega managers were those strategies whose year-end 2012 AUM exceeded $20 billion. AUM manager categorizations were based on PineBridge s opinion of an AUM range where the low end of nimble manager AUM is based on what level would be required to create enough scale for efficient portfolio management whereas the high end of the range is based on a level that would hamper the manager s flexibility in selecting credits. The rolling three-year time period was selected as a reasonable evaluation period to gauge the success of a manager s strategy. Did nimble managers take on extra risk to deliver results? Or were they just lucky? Our numbers suggest neither is the case: Nimble managers delivered compelling information ratios which measure a portfolio manager s ability to create alpha consistently within their risk budgets. 2 If a manager s AUM can be too large, is it also true that a manager can be too small? Our figures suggest this may be so, as the share of smaller managers delivering top-quartile performance is also smaller. A manager must be of sufficient size and scale to attract adequate attention from Wall Street syndicate desks for newly issued bonds and secondary market liquidity. Strength of relationships on the Street is critical. Managers must also have a large enough revenue base to compensate the investment professionals who manage the portfolios. Given the liquidity conditions and size of the investment grade credit market, coupled with the market rate for investment management fees, our peer group analysis suggests the ideal AUM range for a manager in this asset class would fall somewhere between US$2 billion and US$20 billion. 4 PINEBRIDGE INVESTMENTS 2 Median information ratios for rolling three-year period as of 31 December 2015: nimble managers delivered 1.4, versus 1.4 for small and 1.3 for mega managers. Source: evestment Alliance.
Constructing portfolios We believe the ability to express views in an investment portfolio is key to generating consistent, repeatable alpha. A manager s size helps determine the ease or difficulty in expressing and collaborating across an organization to implement these views in a portfolio. As a mega manager, it is difficult to buy enough of a single security to effectively implement your conviction, particularly as more players crowd into the market. Nimble managers consistently outperformed across all time periods. This implies a greater ability to generate alpha on the basis of AUM alone. To help demonstrate this, we constructed a hypothetical diversified portfolio of 100 issuers in the Barclays US Credit index. We kept the percentage held of each bond limited to 5% of outstanding bonds for each issuer to ensure that the manager did not create technical imbalances in the issuers securities that could ultimately impair liquidity. A strategy with US$2 billion in AUM is able to invest in all of the par amount or all of the issuers of the US investment grade index without crossing that 5% line. A manager who needs to invest a US$20 billion portfolio is more limited; the percentage of the available par amount of the index drops to 84%. The percentages drop further as AUM increases, and the opportunity set also decreases as the strategy s AUM increases. In other words, the bigger the fund, the fewer issuers a US investment grade manager can invest in without piling up concentration risk. Diversification becomes difficult at an issuer and sector level. Bigger isn t always better: The hypothetical impact of a 5% purchase of outstanding bonds per issuer of the Barclays US Credit Index, based on a diversified group of 100 issuers Manager A Manager B Manager C Manager D AUM in US investment grade strategy % of index accessible for investment US$2Bn US$10Bn US$20Bn US$50Bn 100% 92% 84% 61% Opportunity set Broad Broad Limited Very Limited Source: PineBridge Investments. As of 31 December 2015. WHY SIZE MATTERS IN INVESTMENT GRADE CREDIT 5
We further analyzed this relationship by relaxing the 5% limitation. The following chart shows how the percentage of index par amount available for 5%, 5%-10%, and 10%-15% of bonds outstanding expands the opportunity set. Nevertheless, as this investable universe expands, it also makes liquidity in buying and selling significantly harder. Finally, if a fund manager owns more than 15% of the issuer s bonds, the exposure becomes unmanageable, especially when positions need to be liquidated quickly and opportunity costs become increasingly significant. 100% Percent of Index Par Amount Outstanding Big exposure, bigger risk % of Index Accessible for Investment by Manager 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% $0 $5,000 $10,000 $15,000 $20,000 $30,000 $40,000 $50,000 $75,000 $100,000 >15% of Issuer Outstanding 10%-15% of Issuer Outstanding Total Assets Under Management in Strategy (US$ Millions) 5%-10% of Issuer Outstanding <5% of Issuer Outstanding Source: PineBridge Investments. Based on the Barclays US Credit Index. As of 31 December 2015. Based on our analysis, tightening the strategy definition leads to even smaller optimal AUM sizes. In the long duration space, the investable universe is even more limited than the general US investment grade universe, so our definition of nimble becomes even more restricted. We believe the larger opportunity set available to nimble managers will result in better performance because these managers can concentrate on security and credit selection and express their views effectively. Accordingly, nimble managers can focus less on non-credit risks, such as duration and currency. 6 PINEBRIDGE INVESTMENTS
Moving ahead Investors demand for yield will continue through volatile markets. In our view, the post-crisis shift will be supported by the structural demands of an aging investor base across the world. If that proves true, we may see more managers move into mega-manager territory with a subsequent decline in performance. Given the challenges all managers face today in searching for yield, it s even more important to be fully integrated across asset classes and geographical areas. For global multi-asset mega managers, the sheer size of their organizations may prove to be an impediment to effective internal collaboration. It could also inhibit them from leveraging the full breadth of their investment professionals expertise. We believe that reduced liquidity is here to stay and with it, the likelihood of greater volatility. As markets face low interest rates and reduced yields and spreads, the ability to consistently and meaningfully express investment views is even more crucial to generate repeatable alpha. Investors should consider the structure of the market, the availability of investable securities, and the overall size of investment managers when seeking strong, consistent returns. WHY SIZE MATTERS IN INVESTMENT GRADE CREDIT 7
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