Passive investing heading 'towards a crisis'

Portfolio manager on the value of fixed income, active management and why investors should be worried about lack of liquidity trading

Passive investing heading 'towards a crisis'

The ETF fee marketing blitz is misleading and could harm investors, according to a fixed-income portfolio manager.

The “race to the bottom” among index tracking products has resulted in a plethora of low-cost options for investors. However, Rohan Thiru, a PM at Canoe Financial, an active independent investment management firm, believes many people do not realize the risks involved.

After exploring the three major risks for passive fixed-income investors in part one of his interview with WP, Thiru turned his attention to fees and the value of fixed income and active management in part two.

He said: “We wake up every day and see how we can add value to investors and preserve capital in fixed income. A lot of these ETF [managers] wake up every day and say, ‘how can we increase our own profit and bring in AUM’. That’s really concerning because I don't think investors realize the risk involved.

“We are heading towards a crisis because of the amount of AUM in passive investing. Not just equities but fixed income as well, which can be exaggerated because of the lack of trading liquidity (see part one). I wish investors saw how bad things got in December of last year.”

Thiru, a portfolio manager on the Canoe Bond Advantage Fund and the Canoe Bond Advantage Portfolio Class, said that done right, core fixed income is a vital protection to equities in an investor’s portfolio. But he feels that many have forgotten this over the past decade and that a period of re-education is required.

He explained: “You should be owning fixed income because it's insurance on your equity portfolio - it's a simple fact. Fixed income investments in your portfolio, in theory, should be negatively correlated to equities and you want to own core fixed income, which means lots of rate duration, very little credit duration and a very defensive portfolio, which is how our fund is positioned right now.

“This is the time to be owning a core fixed-income portfolio because when you have increased volatility in risk assets, when equities sell off, your downside is protected. That's exactly what you saw during the market drop in Q4 last year; when equities were down, we had a 2.4% return during that period. That's exactly what your fixed income should be doing, protecting the downside, preserving capital and generating income for you.”

Active management is, of course, at the centre of what Thiru and Canoe offer. It’s an investment style that is arguably harder to appreciate and identify in the fixed-income space. In an environment like now, he told WP that the active managers are the ones taking significant bets on the market – and are massively underweight credit.

He highlights Canoe’s stance by comparing the fixed income index’s credit duration of 6.5 years with its own 1.7.

Thiru said: “It’s a significant bet we are taking – we are basically saying credit spreads are going wider. We want no action in credit; we are out of it. It's like when an equity person goes all cash, that’s what we are right now. We find credit to be overvalued; fundamentals are very unfavourable and the macro environment looks very scary. I don’t want any part of risk, so that's the bet we have taken for the past year.

“How do you know when one manager is active? Look at the credit duration, look at the ratings, and look at whether they're holding defensive names that can be liquidated in a stress scenario.”

Liquidity is top of mind right now after a December sell-off that, in Thiru’s opinion, exposed smaller dealer inventories and froze the credit market. The days when it would take a huge downturn for this to happen are over, he added, and believes that the amount of debt in the system is unsustainable.

He said: “I would estimate the Canadian dealer book to be about $10 billion and you’ve got about $500 billion of AUM in the index, so dealer inventory can easily fill up very quickly. There is also the point that some dealers are closing the book because they want to have some capacity in the future, so they don't necessarily fill up all of it.

“Therefore, you don't need a large down day in equities for a material sell-off in credit anymore. A lot of people aren’t aware of that. Investors should be concerned about passive investing and the liquidity in fixed-income portfolios."