This summary gives a practitioner’s perspective on “Looking under the Hood of Active Credit Managers,” by Diogo Palhares and Scott Richardson, published in the Financial Analysts Journal 2Q issue 2020.
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This summary gives a practitioner’s perspective on “Looking under the Hood of Active Credit Managers,” by Diogo Palhares and Scott Richardson.
What’s the Investment Issue?
Most actively managed mutual funds and even some hedge funds generate beta as well as active returns. This article investigates just how much traditional risk premiums are responsible for active credit manager fund returns. The article also examines the extent to which alternative risk premiums contribute to active credit fund returns and whether active credit managers take sufficient advantage of alternative risk premiums.
How Do the Authors Tackle the Issue?
The authors perform two types of analysis. First, they compare the betas of actively managed credit funds with traditional credit risk premiums. They aim to uncover to what extent excess returns from credit hedge funds and benchmark-beating returns from credit mutual funds depend on traditional risk premiums.
Second, they analyze whether systematic investment styles, such as value, momentum, carry, and defensive credits, are being used by credit hedge funds and actively managed credit long-only funds. Previous studies have established that these styles are strongly correlated with excess return from credit strategies.
The authors use a longer time series (1997–2018) than those of previous studies and also analyze a relatively wide cross section of actively managed credit funds—219 credit hedge funds, 154 credit mutual funds, and 96 high-yield mutual funds.
In addition, while many studies focus on fund returns only, this article examines the individual holdings (in the case of the mutual funds), thereby increasing the power of the analysis.
What Are the Findings?
There is limited evidence that actively managed credit hedge funds deliver returns that are uncorrelated with traditional market risk premiums. Around half of the variation in returns from credit hedge funds is generated by credit beta. This finding, the authors say, may surprise many hedge fund clients who might expect a full-fee strategy to hedge out the bulk of market exposure and generate its returns predominantly by seeking alpha.
In contrast, clients of credit mutual funds may be surprised to learn that mutual funds offer low exposure to the credit risk premium relative to their respective benchmarks. The average correlation is –0.3. This result, the authors say, at least partly explains the negative net-of-fee returns for credit mutual funds.
Next, although systematic investment themes have been demonstrated to consistently produce corporate bond excess returns, this study shows that credit hedge funds and long-only credit mutual funds are only minimally exposed to these themes. Only 7%–12% of the returns generated by credit hedge funds are due to systematic exposures, and for the 96 high-yield credit mutual funds, only 2% of the excess returns can be explained by systematic exposures.
The examination of holdings in mutual funds reveals a similar picture: There is scant evidence of an active tilt toward systematic investment themes.
What Are the Implications for Investors and Investment Managers?
Investors should be wary of beta exposures in actively managed credit funds: Hedge funds provide too much beta, and mutual funds too little.
To manage their exposures and expectations, investors may want to allocate to a systematic manager alongside a traditional discretionary active manager. Both strategies must be well executed (in particular, distinguishing between alpha and beta) and charge fair fees.
This combination could provide robust diversification given the low return correlation between the risk–return profiles of systematic and discretionary credit managers.