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Opportunities For Alpha With Event Driven Credit Strategies

Editor’s note: Originally published on December 17, 2014 Many investors are aware of event-driven equity strategies, wherein the stock of the acquired company is held long, while the stock of the acquiring firm is sold short, generating arbitrage profits when the deal closes. But many of the same investors may not be aware that event-driven strategies can also be applied to credit instruments, which is the subject of a recent paper by Franklin Square titled Event-Driven Credit Strategies: Opportunities for Outperformance [.pdf]. The objective of event-driven credit strategy is to generate “equity-like returns” with a risk profile more similar to fixed-income. Event-driven equity strategies invest in the stock of companies after the announcement or in anticipation of a “corporate event” – such as a merger or acquisition, a bankruptcy or corporate restructuring, or a shareholder proxy fight. Event-driven credit strategies work under the same premise, but they add two additional “events” to their list: credit-rating changes and “special situations.” Credit Ratings “Investment grade” is the crucial threshold in credit ratings. Standard & Poor’s (S&P) and Moody’s each have different rating scales, but when a company is upgraded to BBB- by S&P or Baa3 by Moody’s, they officially crossover from “junk” to “investment grade” status – and that makes a big difference in the price investors are willing to pay for a company’s bonds. In the U.S., the difference has averaged 180 basis points over the past three years; or 202 basis points globally. By conducting extensive fundamental research, event-driven credit strategies try to anticipate corporate-credit upgrades from “junk” to “investment grade” – or the reverse. A company that’s upgraded to investment-grade credit quality is called a “rising star;” while a company that’s downgraded from investment-grade to junk is called a “fallen angel.” Event-driven credit strategies aim to invest in the bonds of companies before they become rising stars – or short them in anticipation of them becoming fallen angels. According to Franklin Square, “rising stars have generally outperformed similarly rated bonds by an average of 1.5% in the immediate aftermath of an upgrade event.” Special Situations Special situations are another type of event-driven strategy that tends to be more effective for credit strategies than for event-driven equity investors. A typical “special situation” may involve a company that’s under short-term financial stress, but has long-term promise. Event-driven credit investors often extend short-term loans to (or buy short-term bonds from) such companies, normally at above-market interest rates and with terms favorable to the lender. According to Franklin Square, “the average stressed bond issue outperformed the Barclays High Yield Index by an average of nearly 2% per year” over the past decade. Mergers and Acquisitions In the equities sphere, mergers and acquisitions (M&A) are the most prominent corporate events. In May, Hillshire Brands (NYSE: HSH )– manufacturer of Jimmy Dean sausages, among other popular food products – announced the high-profile acquisition of Pinnacle Foods (NYSE: PF ). Pinnacle’s shares soared, but so did its bonds, rising 9.2% on the day of the merger announcement. The above example shows that M&A provides event-driven opportunities for fixed-income investors, too. Indeed, since the early 2000s, the bonds of companies receiving merger bids have outperformed their benchmarks by 3% in the month following the proposed merger’s announcement. Conclusion Franklin Square’s whitepaper concludes with a list of three keys to event-driven credit strategies: Identify market price inefficiencies Initiate a catalyst Introduce equity-like returns Since employing event-driven credit strategies requires skill, expertise, and substantial capital, most individuals seeking exposure use investment vehicles such as mutual funds and closed-end funds. In the view of Franklin Square, investors should consider an event-driven credit fund’s focus, its strategy, its expenses, and its risk profile before investing. Disclosure : No position

What Do Passive Investors Really Mean By ‘Passive Investing’?

The term “passive investing” is actually a misnomer in the manner that most index fund investors use it. The reason why is simple. There is, at the aggregate level, just one portfolio of all outstanding globally cap weighted financial assets. And as soon as you deviate from that global cap weighted portfolio in your asset allocation, you become an “active asset picker” who believes he/she can generate a better risk-adjusted return than that portfolio can. You are, in essence, making a discretionary portfolio decision as opposed to just “taking what the market gives you.” Okay, so the whole idea of “passive investing” is a bit misleading. If you look at this through the macro lens it becomes clear that we are all active asset pickers deviating from global cap weighting. So what do the “passive” investors really mean? First, it’s nice to look at some of the history here because we can start to see why confusion over this terminology has persisted for so long. In The Intelligent Investor, Ben Graham wrote: “In the past we have made a basic distinction between two kinds of investors to whom this book was addressed – the “defensive” and the “enterprising.” The defensive (or passive) investor will place his chief emphasis on the avoidance of serious mistakes or losses. His second aim will be freedom from effort, annoyance, and the need for making frequent decisions. The determining trait of the enterprising (or active, or aggressive) investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort, in the form of a better average return than that realized by the passive investor.” That’s pretty clear. To Graham the distinction is about security selection and trying to earn a premium over the market return. So, active managers are essentially stock pickers who try to “beat the market.” Of course, this was written long before there was an index for everything. Today, most of us don’t pick stocks. We pick an asset allocation by holding financial asset that already have a certain allocation to certain assets. We are still selecting securities of certain types. We just do it differently than one might have in Ben Graham’s day. So Graham’s definition is a bit dated. What about Eugene Fama? Fama has stated that active management is any fund that engages in security selection or market timing. Okay, but anyone who deviates from global cap weighting is “selecting” their own securities inside of index funds. So it really comes down to timing. But this too gets messy. After all, indexers engage in all sorts of active endeavors and simply call it something else like “rebalancing,” “factor tilting” or “dollar cost averaging.” These are all discretionary timing based decisions about how to engage in the markets. They’re just not marketed as “active management” for whatever reason. Okay, so it’s becoming even more obvious that the idea of “passive” investing is a bit messy. But that doesn’t mean the defenders of “passive investing” don’t have important points. In my view, they make many crucial distinctions about portfolio management that every investor should adhere to: You shouldn’t try to “beat the market.” Yes, we all deviate from global cap weighting, but you should build a portfolio that’s right for you as opposed to benchmarking yourself relative to some index. In the aggregate, we all underperform the global cap weighted portfolio after taxes and fees so the “beat the market” mantra is an impossibly high hurdle to begin with. You should keep your costs very low. Costs will destroy a much larger portion of your portfolio than you likely think. In general, my rule is never invest in funds or with managers who charge more than 0.5%. Keep your activity low. The more active you are, the more you’ll increase your tax burden. Like fees, taxes will crush you in the long-run. Pick whole asset classes rather than individual securities. This reduces your risk and allows you to take advantage of diversification. Create a plan that has staying power so you avoid tinkering with your portfolio regularly or letting yourself get in the way. That’s it. This really isn’t about “activity.” After all, we are all active by necessity. But we can be smart active investors. And that’s the key to understanding the distinction between what people call “active” investors and “passive” investors.