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H2O and GAM cases could be the tip of the iceberg for investors

By on March 23, 2021 0

A crisis enveloping a star European bond fund manager this week caused no ripples on Wall Street. However, although extreme and with unique aspects, the sad affair is also extremely relevant on this side of the Atlantic.

Earlier this week, the Financial Times detailed how H2O, a European asset manager owned by Natixis, racked up illiquid debt linked to flamboyant German financier Lars Windhorst. Morningstar quickly suspended the rating of an H2O fund, which “raises concerns about the quality of Natixis’ oversight”, KBW said, sending shares of the French financial group plummeting.

Aside from some of the various allegations circulating, it’s clear that the central challenge is that H2O bond funds have a lot of hard-to-trade securities that can become problematic if investors suddenly want to withdraw their money. A similar crisis enveloped Swiss asset manager GAM last year, when investors fled a range of $11 billion “absolute return” funds that had also plunged into esoteric and illiquid assets.

The problem is that it could be a larger, underappreciated problem in the larger universe of fixed income mutual funds, where clients are promised the ability to withdraw all their money in one blink of an eye, but fund managers were forced to take greater risks. to achieve the returns demanded by investors. In fact, the H2O and GAM cases could possibly be seen as the tip of a nasty iceberg for investors.

At the time, a young bond fund manager strutted around easily. Equity indices are hard to beat, but for various structural reasons bond benchmarks are easier to beat. AQR, the quantitative investment group, studied 20 years of returns from more than 600 US and global bond funds and found “impressive active returns” in the categories it explored. This explains, at least in part, why the passive fund march has been much less powerful in fixed income securities.

However, the AQR report also indicated that outperformance does not come from investment skill – or “alpha” in trading parlance. Bond fund managers seem to have beaten benchmarks mainly by buying corporate debt that is a bit riskier than their target indices. In fact, if one adjusts for a greater weighting towards higher yielding credit, emerging market bonds and longer-maturity debt in general, then you are pretty much all alpha.

In other words, there is no jurisdiction, the newspaper argues. The bond kings and queens simply take on higher risk than the benchmark on average and reap the higher returns than the benchmark, rather than demonstrating a particular aptitude for choosing the right debts to bet on. . “We find fixed income manager alpha to be largely illusory,” is AQR’s damning conclusion.

That might sound a bit harsh, but some big money managers admit to worrying that their industry has sought to counter falling bond yields by simply leaning more heavily toward the riskier segments of the bond market.

Rather than trying to lower their own investors’ expectations, at a time when the average yield for the entire global bond market is 1.7% – and more than $13 billion of debt is trading with yields below zero – fund managers just bought more bric-a-brac bonds, leveraged loans, emerging market debt and other less liquid securities. Or, as in the case of H2O and GAM, bespoke, near-untradable slices of private debt.

Aiming for yield is understandable: after all, fund investors can always find someone else willing to promise solid above-market returns. But this raises a host of risks.

The first is that other situations like H2O will arise during the next recession. That’s not to say they will become mainstream – most fund managers are aware of the dangers of illiquid debt – but there will clearly be more debacles. And a few rotten apples can easily ruin not only the barrel, but the whole warehouse.

The GAM mess, for example, was originally contained in its lineup of absolute return bond funds, but damaged the asset manager’s reputation, cost the CEO his job and shareholders hundreds of millions of dollars. . It’s too early to assess the fallout from H2O, but judging by Natixis’ share price plunge, investors are clearly concerned that it’s a real concern.

But perhaps the most important and pernicious problem is that liquidity risks are fundamentally changing the dynamics of managing institutional investment portfolios.

Bonds are typically the ballast used by investors to protect their larger portfolios against downturns. When stock markets are choppy, fixed income securities tend to perform well. But even with strong bond funds that add riskier debt to their returns, investors may discover – to their horror – that the supposedly safe part of their portfolios is no such thing.

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