Multi-Asset

Analyzing the opportunities for active management

While the longer-term effects of the virus are uncertain, we expect economic weakness and market volatility to continue presenting opportunities for active management.
May 2020

COVID-19 has become an existential threat to many companies around the world due to the dramatic interruption of economic activity caused by the crisis. In this environment, company fundamentals have become more crucial to understanding what the business landscape of the future may look like. This dynamic creates opportunities for active investors as they seek to avoid companies that may not survive and buy companies that may thrive coming out of the virus slowdown. The virus has already created some significant dislocations in the market, giving traders attractive entry points for indiscriminately sold securities. While the longer-term effects of the virus are uncertain, we expect economic weakness and market volatility to continue presenting opportunities for active management, particularly in fixed income and international equities.

Fixed income

The opportunity for active managers in fixed income begins with the inherently defective construction of issuance-based indexes. The explosion of Treasury issuance at historically low rates has anchored nearly half of the Bloomberg Barclays U.S. Aggregate Index (Index) to meager yields. While this large Treasury allocation means “owning the index” is more stable from a credit perspective, agency mortgage-backed securities (MBS) offer relatively attractive yields (52 basis points option-adjusted spread as of 4/29/2020) in the current environment. Increasing exposure to agency MBS can add excess return potential to an active portfolio without a significant increase in credit risk.

Dispersion within credit sectors and among individual credits has increased during the COVID-19 crisis and is likely to continue in the post-virus environment. This offers an opportunity for active managers to identify worthy credit risks and their relative-value placement in a diversified portfolio. Skilled credit analysts can help an active manager select high-quality credits while also adding to securities that have been punished by the market. The significant surge in ratings downgrades and historical amount of “fallen angels” illustrates this opportunity. Robust credit research can identify companies with adequate liquidity to meet liabilities through the current crisis.

Asset-backed securities (ABS), which represent less than 1% of the Index, also offer some compelling opportunities for active managers. Like other fixed income sectors, this area is vulnerable to the challenging economic backdrop. Though the Federal Reserve’s Term Asset-Backed Securities Loan Facility (TALF) measure provides a funding backstop for investment-grade U.S. ABS, it is difficult to assess losses in consumer areas such as credit-card debt and auto loans. However, an active manager could avoid riskier securities backed by credit-card loans and focus on defensive areas like government-guaranteed student loans.

ABS minus corporate AA spread

Analyzing the opportunities in active management - ABS minus corporate AA spread

Source: Bloomberg

Fixed income markets’ response to the crisis has also created an opportunity for buyers to achieve a liquidity premium. The panic selling and evaporation of liquidity in March was historic. This dislocation is likely to continue, given the uncertainty surrounding the post-COVID-19 world (e.g., the additional need for cash, continued economic stress as the Fed’s backstops unwind), and should present an ongoing opportunity for active managers.

Average bid/ask spreads across all sectors of fixed income widened significantly as the market seized up. The table below represents an estimate of average levels, with some specific securities or sectors much wider still.

Sector Bid/ask spreads normal markets Bid/ask spreads stressed markets

U.S. Treasuries

$0.03

$0.10

Agency MBS - pools

$0.06

$1.50

Non-agency MBS

$0.50

$6.00

Agency CMBS

$0.25

$3.00

Sr conduit CMBS

$0.50

$2.50

Sr FFELP

$0.50

$3.50

AAA CLOs

$0.50

$3.50

IG credit

$0.25

$4.00

HY credit

$0.50

$4.00

Bank loans

$1.00

$5.00

As a result of these factors, we believe diverging from issue-based indexes in fixed income markets may offer investors better results into the near future. Active managers can concentrate their corporate exposure within defensive sectors and focus on longer-duration bonds from well-capitalized issuers, which can benefit from tighter spreads when the economy heals. As higher-quality sectors and securities recover and the market approaches a “normal” environment, active managers can turn their focus toward lower-quality bonds in more credit-sensitive areas with the aim of adding value over a passive approach.

International equities

The international equity market is fertile ground for active management in most market environments, given the wide array of idiosyncratic opportunities. This includes more than 24,000 securities in two dozen developed countries and 18,000 securities in more than 77 emerging and frontier countries.

The idiosyncratic nature of these markets has only increased as a result of COVID-19 affecting different countries in different ways. The United Kingdom, for example, may suffer greater economic damage due to its slower response to the virus. Within areas hardest hit by the crisis, well-capitalized, industry-leading companies are likely to benefit from market consolidation. For example, consumer businesses with the liquidity to outlast the crisis will take market share from competitors who do not.

As company boards consider ways to counter COVID-19’s crushing impact on financial stability, dividends are a likely target. Markets with a greater number of high-payout financial and energy companies are particularly exposed. Fundamental research may help decipher how the crisis may variously affect companies’ balance sheets and revenues. This analysis may then allow an active manager to trade out of susceptible names while a passive investor has no option but to own the high-yielding “falling knives” and ride prices down.

The post-COVID-19 market environment in international equities is likely to be defined by a wide dispersion of winners and losers. We believe skilled active managers will be able to identify companies with the financial strength to endure this economic downturn and whose securities have been sold off indiscriminately. We expect active portfolios to benefit as economies recover and these securities are once again appreciated by the market.

Conclusion

As a core tenet of our portfolio construction process, we thoughtfully combine active and passive approaches according to our assessment of the potential benefits arising from sector allocation and/or security selection. We also selectively lean in to active or passive during different market conditions. We believe the current environment warrants greater active exposure within fixed income and international equities.

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Disclosures

This is not intended to serve as a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment at this date and are subject to change. Information has been obtained from sources we consider to be reliable, but we cannot guarantee the accuracy. This presentation may contain forward-looking statements. “Forward-looking statements,” can be identified by the use of forward-looking terminology such as “may”, “should”, “expect”, “anticipate”, “outlook”, “project”, “estimate”, “intend”, “continue” or “believe” or the negatives thereof, or variations thereon, or other comparable terminology. Investors are cautioned not to place undue reliance on such statements, as actual results could differ materially due to various risks and uncertainties. This publication is prepared for general information only. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investment involves risk. Market conditions and trends will fluctuate. The value of an investment as well as income associated with investments may rise or fall. Accordingly, investors may receive back less than originally invested.

Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index that covers the U.S. investment-grade fixed-rate bond market, including government and credit securities, agency mortgage pass-through securities, asset-backed securities and commercial mortgage-based securities. Investments cannot be made in an index.

The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option.

Basis points (bps) represent 1/100th of a percent (for example: 50 bps equals 0.50%).

Foreign investing involves special risks due to factors such as increased volatility, currency fluctuation and political uncertainties. Investing in emerging markets can be riskier than investing in well-established foreign markets.

Past performance is not necessarily a guide to future performance. Asset allocation does not ensure a profit or guarantee against loss.

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