On the Bond Selloff

Mohamed El-Erian writes,

Advocates of the active strategy will note that investors who relied on indexing ended up overexposed to energy and energy-related risk. As a result, they were particularly hard hit by the collapse in oil prices. As liquidity-induced contagion spread to securities in others sectors with more solid fundamentals, the remaining diversification potential of the high-yield index brought them little relief. And those seeking to pull out their money faced additional losses thanks to widening bid-offer spreads.

Advocates of passive investments will note that the biggest losses in the asset class so far largely have been  incurred by active funds. This is especially true of managers who ventured away from the index and into more exotic, even-more-illiquid names. Inadequately constructed portfolios are adding to their woes, and some of these funds are having trouble raising cash, further undermining their investment strategies.

There are two immediate takeaways:

  • Investors should be wary of adopting a passive approach in asset classes subject to high credit/default risk and in which weights are calculated on the basis of the debt outstanding for each issuer (which, unfortunately, is the traditional approach to the design of too many indexes).
  • Those following an active approach should be cautious about asset managers who combine an open-ended vehicle offering daily liquidity with a repeated strong inclination to venture deep into exotic and illiquid names in search of returns.

A wider application of these two simple principles leads to a broader conclusion:

Rather than focus on extremes, a responsive mix of passive and active investments is the best approach for many investors. They should be inclined to use passive approaches for asset classes that are heavily favored by the investment community as a whole, and where the addition of alpha is inherently difficult. They also should be more attracted to active approaches for the less popular market segments, such as exotic asset classes, for which they can use liquidity-conscious managers with well-tested investment processes, rather than relying on vulnerable indexes.

More from here.

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Lady FOHF writes,

Not dead, but certainly poorly. Third Avenue is important because it raises questions about asset/liability matches that to date investors have largely avoided because while everyone was talking about liquidity concerns in fixed income markets, evidence was mixed and managers still needed to generate returns so they chose to ignore the big illiquid elephant in the room. That a mutual fund is to some extent avoiding price discovery on less liquid assets by choosing to suspend redemptions rather than attempt to sell those assets is a wake up call particularly to investors who were considering their (under-performing) high yield allocation in both the hedge fund and mutual fund space. Add to this further hedge fund closures in the space (Lucidus, Watershed) and the likelihood of more redemptions and subsequent suspensions rises.

Third Avenue and Stone Lion are small funds in terms of assets, but from a sentiment point of view (not least because of a financial media that has caught a whiff of the next crisis) at the wrong time and in an already expensive market they can have a significant impact, not least because it isn’t yet entirely clear how retail investors will react.

Do read all of it.

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