Is Your Manager Nimble? The Sweet Spot for Managers in Investment Grade Credit

So 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, our analysis shows that managers with lower assets under management can move more effectively in and out of positions in markets where liquidity has dried up – and those in the “sweet spot” for AUM have greater potential to generate alpha.

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.

The big squeeze

Following the global financial crisis, regulations such as the Volcker Rule and Basel III capital requirements curbed banks’ ability (and willingness) to hold large inventories of corporate debt on their balance sheets. As a result, post-crisis dealer inventories fell even as debt issuance increased substantially, a trend that has continued today.

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, squeezed liquidity, and fundamentally shifted the market dynamics. Moving larger blocks of bonds is more difficult today.

Shifting Dynamics: Credit Markets Continue to Expand While Dealer Inventories Decline

Source: Federal Reserve Bank of New York and Bloomberg as of 6 April 2022.

Measuring performance

For investors, the key question is whether falling inventories 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 total strategy assets under management (AUM) for the 2014-2018 period and ensured they stayed within the bounds of our definitions of small, nimble, and mega managers (see table) for this period. This also helped 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, five, seven, and 10 years versus the Bloomberg US Credit Index.

Rolling Three-Year Alpha Versus Bloomberg US Credit Index by Manager Size

Source: eVestment Alliance. As of 31 December 2021. Universe construction methodology: eVestment US Corporate Fixed Income universe was screened to only include strategies that have listed the Bloomberg US Credit Index or Bloomberg US Corporate Investment Grade Index as the preferred benchmark. Peer groups were further segregated based on the period 2014-2018. The small managers were those strategies whose AUM was $2 billion or less for the period. Nimble managers were those strategies whose AUM was greater than $2 billion and less than $20 billion for the period. Mega managers were those strategies whose AUM exceeded $20 billion for the period. 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 periods were 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.1

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.

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 of expressing these views and collaborating across an organization to implement them in a portfolio. A mega manager may find it difficult to buy enough of a single security to effectively implement its conviction, particularly as more players crowd into the market.

To help demonstrate this, we constructed a hypothetical diversified portfolio of 100 issuers in the Bloomberg US Credit index. We limited the percentage of each bond held 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 88%. 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.

Finding the Sweet Spot

The hypothetical impact of a 5% purchase of outstanding bonds per issuer of the Bloomberg US Credit Index, based on a diversified group of 100 issuers

Source: Bloomberg based on the Bloomberg US Credit Index, as of 31 December 2021.

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 more challenging.

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.

Big Exposure, Bigger Risk

Percent of index par amount outstanding

Source: Bloomberg, based on the Bloomberg US Credit Index, as of 31 December 2021.

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.

Moving ahead

Investors’ demand for yield will continue through volatile markets, supported by the structural demands of an aging investor base across the world. If this proves true, we may see more managers move into mega-manager territory and face a potential 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 geographies. 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 as central banks tighten pandemic-related policy – and this brings the likelihood of greater volatility. With markets now facing rising interest rates and wider spreads, the ability to consistently and meaningfully express investment views is even more crucial to generating 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.

Footnote

1 Median information ratios for rolling three-year period as of 31 December 2021: Nimble managers delivered 1.05, versus 1.03 for small managers and 0.8 for mega managers. Source: eVestment Alliance.