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High-Yield Credit: The Case for Systematic and Discretionary Management

A new look “under the hood” at active credit managers comes from a paper written by two executives at AQR Capital Management.

Diogo Palhares and Scott A. Richardson find that long/short fixed-income managers have a high exposure to the credit risk premium. But high-yield-focused long-only managers provide less exposure to that premium than do the pertinent benchmarks.

Palhares and Richardson, looking at both mutual and hedge funds with these credit-based strategies, say that they do not have any meaningful exposure to well-compensated systematic factors, so they find potential in this space for a “powerful diversifier” to institutional portfolios. That is, if systematic managers do come into this space, they will fill an important near-vacuum.

The Database

The AQR authors use a database that includes 219 credit hedge funds in the HFR database—both the live and the graveyard files—as well as 96 mutual funds benchmarked to a high-yield corporate bond index. They are working, then, to minimize survivorship bias in their data. Also, they observe that the high-yield index is covered by both Morningstar and Lipper.

The authors look at data extending from 1997 through June 2018. As the authors observe, this gives them 264 months for returns analysis (using net-of-fees monthly return data), and 88 quarters for analysis based on holdings.

The average credit hedge fund has a positive net-of-cash return and a Sharpe ratio of 0.79.

Exposure: Too Much or Too Little

Palhares and Richardson begin their study by looking at whether the excesses of cash returns for actively managed hedge funds, and for the analogous mutual funds exhibit any correlation to traditional risk premia. They find that there is a correlation. In their words, “[T]he strength of this result is sobering,” across the 219 credit hedge funds, looking to the median manager’s performance, nearly 40% of the time series variation in excess of cash return can be explained by passive exposures, especially to equity, credit, and term premia.

In the high-yield long-only mutual funds, the correlation is not as striking. Indeed, in that space there is a negative correlation, particularly to the credit premium. The persistence in this beta mismatch is, Palhares and Richardson observe, “inconsistent with the attempt to time the market, let alone demonstrate skill in such timing.”

Arguably, this means that the hedge funds involved are providing too much exposure to these factors, given their alternative/hedging role.

The negative correlation may come about because the high-yield managers “cannot enhance returns by adding persistent out-of-benchmark exposures to risky credit.” Indeed, they tend to operate in the opposite direction, skirting headline risk by avoiding the riskiest issuers.

So the former group may be providing too much exposure and the latter may be providing too little for the comfort of many investors. “In both cases,” the AQR authors write, “the implication for investors is to pay attention to the traditional ... premia embedded in their active credit manager allocation and further to make sure that the fee you paid for that traditional market risk” is a low one.

Gaps in Market and Scholarship

Palhares and Richardson want to help plug what they see as a gap in the literature, which corresponds in their view with a near-gap in the market. Although there has been a lot of research about the applicability of systematic approaches to the equity markets, the applicability of the same approaches to the fixed-income markets has been left mostly unaddressed. The time is ripe for plugging that gap, they say, given the expansion of the corporate bond market, the rise of Big Data, and a greater awareness of the issues involved since a paper by Correia, Richardson and Tuna in 2012.

Accordingly, Palhares and Richardson make the case that “an allocation to a systematic credit manager alongside a traditional discretionary active credit manager has the potential to be a powerful diversifier,” where the “systematic” manager is understood as one who targets the factor attributes.

It doesn’t follow that the systematic approach is superior to the discretionary approach. Rather, say these authors, “if both are well executed and charge fair fees, they may complement each other very well.”