Friday’s big news that Bill Gross was to leave PIMCO, the bond house he co-founded in 1971, almost instantly led to questions being asked about bond market liquidity and what the possible impact might be on investors.
Bond market liquidity has come under a lot of scrutiny of late, if I had a pound for every time I’d been shown the graph below (a quick Google search
shows many versions – hat tip to FT Alphaville
in this case) then, well, I guess I’d have at least £25 (just about enough for a round in the City…). It seems like a relatively compelling chart with a clear story – the bond market is bigger, but the banks are providing less balance sheet to support their market making desks, meaning there is, supposedly, a shortage of dry powder to buy bonds when the market struggles. But does liquidity really matter?
How bond behemoths compare to boutiques
What is clear is that the larger unconstrained bond funds out there have been struggling to earn significant returns from bottom up stock selection for some time. Earlier in the year, Bill Eigen, Portfolio Manager of JPM’s $26bn Strategic Income Opportunities Fund, came under criticism for holding half the fund in cash (currently at 63%+) – a clear admission that he can’t find enough individual bottom-up opportunities to add value for fund investors. Instead, he hopes to add value via top-down asset allocation alpha – presumably by adding credit beta after credit spreads have widened. This type of top-down call will be all too familiar to Gross-afficionados, who will of course remember the former PIMCO supremo’s ill-timed 2010 call on gilts (“resting on a bed of nitroglycerine
”) as well as his decision to aggressively shorten duration somewhat too early in the cycle, which cost his investors in 2011 and again so far in 2014.
The alternative for the monster funds that struggle to add value on a stock by stock basis is to add leverage, as several large bond houses have done over the past 12 months - in a move uncannily reminiscent of the prelude to the last bond market breakdown - effectively turning assets yielding 3% into assets yielding 5.5% with a turn of debt. It works for now, but it isn't real value-add, is it?
What is unclear is why people ever bought into this type of approach. Isn’t it easier to add value via intensive stock selection and in-depth corporate research rather than by picking the general direction of interest rates or credit spreads? When is a fund too big? If it’s an active one, surely the answer is “whenever you get too big to be bottom-up”? Or how about “whenever you get too big to sell a downgraded bond in a sensible time frame”?
Consider the following scenarios; a bond manager holding $50mn of a particular bond holding is trying to sell the bond at the same time as a $2bn holder. Each day the market can digest, let’s say, $100mn of bonds. In a simplistic world with just two fund managers, the small manager is out of his holding on day 1, whilst the larger fund manager takes 20+ days to liquidate his position. Clearly the world is more complicated than this, but given that everyone seems to be worried about the rush to the exit in corporate bonds, wouldn’t you want to be a boutique in this market rather than a behemoth?
Fund management boundaries are breaking down
Advisers have started to realise this; Towers Watson’s head of fixed income research Chris Redmond made some similar comments
back in August, saying “We are applying a slightly higher bar [and] thinking about size, style and the new liquidity regime. People who have a strategy that is reliant on strong liquidity and have been lulled into a false sense of security will suffer when the market changes.”
This is a fascinating comment, and timely, because boundaries are being broken down in fund management – you can no longer draw an easy line between long-only asset managers and hedge funds; there is a new breed of boutique asset managers who fall somewhere between the two – with the absolute return mindset of a hedge fund but the institutional grade investor base of a long-only asset manager. These boutique asset managers, as Mr Redmond may have noted, offer you the best of both worlds – stock selection, high levels of client service, but while remaining agile enough to navigate the “new normal” of illiquid credit markets.
What to look for when assessing boutique fund managers
The rise of the bond boutique does not mean additional workload to assess their suitability in your portfolio. You don’t need to know every manager, you do need a high conviction and inside-out knowledge of those you invest with. The approach for both behemoths and boutiques should have a clear process to screen, select and monitor managers. Under each step, with respect to liquidity, it is useful to consider these questions:
These issues were raised with fund managers earlier this year, you can see the slides here
So, does liquidity matter?
Yes, liquidity does matter. It is, however, just one of several factors to consider when selecting a manager. Liquidity matters, but so do size, culture, transparency and fees. My next blog will cover these factors in more detail.