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The liquidity pitfall of passive investing

The liquidity pitfall of passive investing

25-08-2014 | Insight

Investing in ETFs can be very risky, especially during periods of limited liquidity. Patrick Houweling and Victor Verberk explain why and how active management and the use of derivatives can provide both a solution and an investment opportunity.

  • Patrick  Houweling
    Patrick
    Houweling
    Co-Head of Quant Fixed Income
  • Victor  Verberk
    Victor
    Verberk
    CIO Fixed Income and Sustainability and Portfolio Manager of Robeco Global Credits

Decreasing liquidity is changing the market

In recent years, investors in corporate bonds have been confronted with decreasing market liquidity. This is mainly attributable to the changed attitude of investment banks. Banks have become more cautious due to the financial crisis and have therefore reduced their corporate bond trading activities. In addition, banks are maintaining higher capital ratios because of stricter regulations. They trade less often for their own account and focus mainly on bringing buyers and sellers together. 

Patrick Houweling, senior quantitative researcher and fund manager of the Robeco Quant High Yield Fund, concludes that the reduced liquidity could cause problems for investors in passive funds. "The credit market has grown significantly in recent years, also because of the increased popularity of ETFs. In normal market conditions, ETFs can be traded quite easily. However, when markets turn and corporate bonds go out of favor, investors can be unpleasantly surprised. Passive funds typically mirror their underlying index. As a consequence the fund managers must sell and buy certain bonds regardless of market conditions. When adverse market conditions prevail and a large number of investors wish to sell bonds without finding enough buyers to match supply, this may cause the investments in the ETFS that are based on full replication to be sold considerably below their net asset value. This applies mainly in turbulent markets." 

'In turbulent markets, ETFs are sometimes sold far below their net asset value' 

Houweling illustrates this with an example: "Corporate bonds were under pressure in May 2012 due to the uncertainty about Greece. The market price of a corporate bond fund normally lies above its net asset value. However during that period, the market price of the iShares-tracker in European high-yield bonds was up to 89 basis points lower than its net asset value. The reverse is true as well as this could also work the other way around when passive fund managers need to buy in buoyant markets conditions. In that case, they will pay too much for the bonds they need to replicate their index. This occurred in July 2012."

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Uncertainty about Greece brought the price of the high yield tracker below the net asset value
Source: Robeco, Bloomberg

Active management avoids crowding at the exit

Victor Verberk, co-head of the credit team, says that when investors opt for active management they will no longer have to worry about executing orders in unfavorable market conditions and avoid crowding at the exit. "Managers of actively managed funds have various buttons that they can press. First of all, as a fund manager you can seek to profit from market movements. It is often unwise to sell during periods of market stress. Markets often overreact. This is mainly due to parties such as ETFs that are obliged to replicate their benchmark. Active management allows you to capitalize on this situation. If you would like to reduce the size of your portfolio, you can use that moment to sell less attractive bonds and – vice versa – if you are enlarging your portfolio you can buy additional expected outperformers. You must have the courage to trade contrarily. As an active investor, you can thus profit from forced buying and selling by passive funds. In fact, you can collect the premium that they need to pay."

'As an active portfolio manager, you have more buttons that you can press' 

"A second advantage of active management is that you can maintain a somewhat larger cash position. A lack of liquidity in the market is not a problem if you do not necessarily have to sell or buy immediately. The cash position makes this possible. Furthermore, you can reinvest the cash in bonds that are liquid at any moment." 

According to Verberk, the third button which the fund manager can press is the composition of the portfolio. "Actively managed funds can deviate from the chosen benchmark. Not only does this provide flexibility, it can also lead to an advantage in stressful markets. In June 2013, when there was unrest in connection with the Fed policy, we were able to sell triple-A asset backed securities relatively easily. 

Finally, you can also make use of credit derivatives in the portfolios. These are generally more liquid than bonds issued by the same company."

Making use of liquid credit derivatives

Houweling has recently been appointed manager of a fund that predominantly invests in credit derivatives. "The Robeco Quant High Yield Fund is a very liquid solution to invest in credits. The portfolio consists of credit default swap (CDS) indexes, which are much more liquid than individual corporate bonds. This is very appealing from a risk perspective. Due to the absence of an illiquidity premium, CDS indexes suffer much less in bear markets. Another advantage is that CDS have a 'bullet structure'. This means that, unlike many high yield bonds, they cannot be redeemed in advance. This is a positive feature for the return potential of CDS.”

'With CDS indexes, you can profit from market trends at lower costs'

"Because of the high liquidity of the CDS indexes, you can actively and cheaply position the portfolio to profit from market trends. The fund uses a proven quantitative model, which we have used now for many years, to vary the beta of the fund between 0.5 and 1.5. Such a quantitative investment style offers diversification for investors in addition to fundamentally managed funds. Moreover, the fund is interesting for investors with a tactical investment view. For these investors, who would like to implement their investment view actively, the large degree of liquidity and the low costs are very favorable." 

Houweling concludes that liquidity in the corporate bond market does not have to be a problem. "Active management and the use of derivatives offer both a solution and an investment opportunity."

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