Active or passive? Which is best for a global credit investor?

23 April 2018 | Portfolio construction


 Remove  Save

Abstract square image

Commentary by Andreas Nagstrup, Vanguard credit analyst.

The question is often asked whether index funds make sense when it comes to credit investing.

The key challenge with indexing a global corporate credit fund is that the benchmark may consist of several thousand securities. Given the over-the-counter (OTC) nature of the credit market and the bid-offer spreads, the cost drag of fully replicating such a large universe would make it near impossible to match the benchmark performance.

But that is not quite the end of the story. If you can't replicate the index, you can sample it. The aim here is to pick securities that in aggregate replicate the characteristics of the benchmark with respect to duration, credit quality, capital structure (senior or subordinated securities), beta, sector, country and currency. In this way, an index of 11,000 bonds can be reduced to a portfolio of 2,000–3,000 bonds.

The new issue market is a particular challenge for index funds. Issuers often offer concessions to entice investors to buy a new bond, and there are no transaction costs. The decision is whether to buy the bond at the time of issue, taking advantage of any concessions and lower costs, or to wait until it goes into the index at the end of the month, by which point it may have either gained or lost value, and you will then incur transaction costs.

The process for active credit investing is in principle not all that different. An active fund evaluates the same risk factors. However, the aim of an active fund is not to replicate the characteristics of the benchmark but rather to have deliberately different exposures to at least some of these risk factors in the hope of generating a return above the benchmark. Active funds, depending on their objective and its constraints, may be able to take exposure away from the benchmark to further improve performance.

Active funds tend to run more concentrated positions compared to an index fund. Where an index fund may run 2,000–3,000 positions to replicate the risk factors of its benchmark, an active fund may only run a few hundred positions, securities based on the fund manager's conviction that they will collectively outperform the benchmark.

In the current low-yield environment costs are more important than ever for investors. Active funds tend to be more expensive than index funds. A passive fund may or may not draw on the input of research analysts to pick the right securities to replicate the characteristics of the index, but an active fund will almost certainly use analysts to give the edge necessary to outperform.

As long as costs are proportionate to potential rewards, both active and passive funds can be appropriate choices for a portfolio. Active credit funds can offer additional performance, while a passive fund will usually be a lower cost means of gaining exposure to the broader market.

In conclusion, index funds do make sense in credit investing. Traditional active funds make sense too. Either can be a great choice for your portfolio. Credit research analysts can play an important role in the management of both active and index credit funds. In the current low-yield environment investors need to pay particular attention to costs, whether you invest in an active or an index credit fund, to give yourself the best chance of investment success.

Andreas NagstrupAndreas Nagstrup
Vanguard credit analyst

Important information:

This information is directed at professional investors and should not be distributed to, or relied upon by retail investors.

This article is designed for use by, and is directed only at, persons resident in the UK.

The material contained in this document is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.

The information in this article does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this article when making any investment decisions.

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.

The opinions expressed in this article are those of the individual author and may not be representative of Vanguard Asset Management, Limited.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.


 Remove  Save