Active credit funds seen outperforming in 2010

Date: Thursday, October 8, 2009
Author: Jane Baird, Reuters

* Correlation is declining as asset prices diverge

* Default risk remains, while margin for error thinner

* Market rife with dislocations, opportunities

Active credit fund managers are set to enjoy stellar returns in 2010 as individual company performance supplants the financial crisis as the crucial driver of prices.

Passive managers who track indices -- as opposed to funds that focus on picking names, or hedge funds with long/short strategies-- have performed strongly since March as all credit assets have risen.They were helped by market-wide recovery in credit markets from a year ago.

But now as financial conditions start returning to normal, the correlation between asset prices will start to diminish, and the performance of individual companies will be increasingly diverse, Goldman Sachs credit strategists said in a report.

"Relative-value active management will gradually outperform passive management over the next year," said Alberto Gallo, Goldman credit strategist in an interview.

That was not true in 2008, when over 75 percent of active U.S. fixed-income managers underperformed benchmark indexes, and passive managers were in the top quartile, said Chris Redmond, senior investment consultant at Watson Wyatt Worldwide.

Watson Wyatt advised clients to "avoid a knee-jerk reaction of selling active funds and going passive" after 2008, he said.

"Cycle through to 2009, and we have seen the flip situation where active managers have been on top," he said, adding that 2009, 2010 and 2011 may provide fertile ground for "best-in-class" managers and active management in general.

"It's lining up for a far more interesting and productive period for relative value and long/short investing," said Simon Thorp, chief investment officer of Liontrust Credit Fund.

The return of liquidity into the market has made relative-value trading profitable again, Thorp said. Bid-offer spreads are no longer at extremely wide, dislocated levels.

But the margin for error in buying credit is smaller. "The default risk is still there, because we are going to have a slow recovery, but spreads are lower, so you have to be much more careful about what you buy," Gallo said.

 

LOTS OF OPPORTUNITIES

Looking at previous post-rececession periods, Goldman found correlation typically dropped and that long/short hedge funds outperformed macro hedge funds.

"Instead of doing directional bets, which have worked pretty well so far, now to extract returns you will have to do more bottom-up work and look at companies that will perform in a slow recovery," Gallo said.

Systemic risk has fallen, but the market is still rife with dislocations and opportunities for relative-value trades. After the general rally, spreads do not reflect fundamental differences between companies and industrial sectors.

Liontrust sees opportunities to buy in two areas: non-bank financial firms, such as Euroclear Finance, with no exposure to problem areas but that have been hit along with the rest of the sector, and debt instruments with creditor-friendly options or twists that have been overlooked.

"If you really dig around and read the small print, you can find Tier 1 pieces of bank paper that are puttable in six months' time and are yielding an annualised rate of return of over 20 percent, said Thorp"

Now that the rally has lifted all ships, Liontrust is also starting to see opportunities to short investment-grade firms that are likely to fall to junk or high-yield borrowers at a risk of default over the next 18 months, he said.

Nowadays Liontrust looks only at ideas with annualised returns of at least 12 percent on an unlevered basis, and that target is down from 20 percent three months ago, Thorp said.