Research suggests credit mutual funds and hedge funds are not delivering outperformance
An article in the most recent CFA Institute Financial Analysts Journal looks “under the hood of active credit managers” to better understand what powers their excess of benchmark returns, which are often attractive. The style exposures of actively managed equity funds have been extensively researched and many investors therefore adjust equity manager outperformance for their exposure to traditional market premia (betas). However, this is less true in relation to active credit managers, where manager outperformance is often taken at face value.
In the article, authors Diogo Palhares and Scott Richardson from AQR Capital Management examine how active credit managers, both active hedge funds and active long-only mutual funds, generate their outperformance. The key question is the same in credit as it is in equities: are investors getting the amount of market exposure and uncorrelated outperformance that they are expecting?
Many credit hedge fund investors are paying full hedge fund fees with the expectation of receiving exposure to sources of return that are uncorrelated to traditional investments, while having close to zero market exposure. In an active long-only mutual fund, investors likely expect to have full (100%) exposure to market risk (in this case, credit risk premium) along with uncorrelated active returns.
The authors suggest neither credit hedge funds nor long-only credit mutual funds are delivering what investors would conventionally expect of them – the hedge funds deliver too much beta, while the mutual funds deliver too little. Furthermore, neither of these fund types seem to have meaningful exposure to systematic credit factors that are expected to be well-compensated, such as value, momentum, defensive and carry factors.
The researchers used an exhaustive set of data from active credit funds. Many studies focus on fund returns only, but this article also examined the individual portfolio holdings (in the case of the mutual funds), increasing the power of the analysis. This study boasts a longer historical window of data than previous studies (1997 to 2018) and a wide cross section of actively managed credit funds: 154 credit mutual funds and 96 high-yield mutual funds in all.
The authors performed two types of analysis. First, they compared the betas of actively managed credit funds with traditional credit risk premia to uncover to what extent excess returns from credit hedge funds and benchmark-beating returns from credit mutual funds are dependent on traditional market risk premia.
Second, they analyse whether actively managed credit hedge funds and credit mutual funds provide meaningful exposure to well-compensated systematic factors. These include value, momentum, carry and defensive themes. Previous research has established that these systematic themes can explain a significant portion of cross-sectional variation in corporate bond excess returns.
The authors find limited evidence that actively managed credit hedge funds deliver returns that are uncorrelated with traditional market risk premia. About half of the variation in returns from credit hedge funds is generated by credit beta or passive exposure. This, the authors say, may surprise many hedge fund clients who expect a full-fee strategy to hedge out the bulk of market exposure and generate its returns predominantly by seeking active “alpha”.
Clients of credit mutual funds may be similarly surprised to learn that mutual funds offer low exposure to the credit risk premium relative to their respective benchmarks.
Although systematic investment themes have been demonstrated to consistently produce corporate bond excess returns, the paper shows that credit hedge funds and long-only credit mutual funds are only minimally exposed to these themes.
The examination of holdings in mutual funds reveals a similar picture: scant evidence of an active tilt toward systematic investment themes.
What does this mean for investors? To better manage their exposures and expectations, investors in active credit may want to allocate to a systematic manager alongside a traditional discretionary active manager. Both strategies must be well executed (in particular, distinguishing between alpha and beta) and charge fees that are a fair reflection of the managers’ activities. This combination could provide robust diversification, given the low return correlation between the risk-return profiles of systematic and discretionary credit managers.
Heidi Raubenheimer is the head of journal publications at the CFA Institute