When it comes to leveraged loans, active investing beats passive

New York

Like junk bonds, which have been shown to perform better in actively managed portfolios than passive ones, leveraged loans also appear to have a similar bias.

Since their inception in 2013, the two actively-managed leveraged loan exchange-traded funds in the market — the $1.25 billion First Trust Senior Loan ETF, symbol FTSL, and State Street Corp’s $1.6 billion SPDR Blackstone/GSO Senior Loan ETF, which goes by SRLN — have posted better returns than the two index-tracking loan ETFs — the $498 million Highland/iBoxx Senior Loan ETF, symbol SNLN, and Invesco Ltd’s $9.3 billion PowerShares Senior Loan Portfolio, or BKLN, according to data compiled by Bloomberg.

The reason is simple, say the managers who oversee actively managed loan portfolios. With these debt securities, individual selection is crucial — and an index-driven approach doesn’t provide it.

“We see this as an area in the market where active is a better avenue because mangers can be more selective and leverage their expertise in an area that’s less efficient than large US stocks,” said Ben Johnson, director of global ETF and passive strategy research at Morningstar Inc.

Size Matters

Debt indexes differ from equity indexes because of the focus on size. In stocks, market capitalisation is an indication of investors’ view on the company, the larger it grows the more optimistic they are. So a market value-weighted index captures this. But loan size says nothing about a company’s outlook, just that people were once willing to lend it a certain amount of cash.

Take iHeartMedia Inc, the San Antonio, Texas-based radio broadcaster that headlines the distress debt playlist. Given that iHeart has $6.3 billion of term loans outstanding as of December 31, 2016, both passive ETFs list the name among their top 15 holdings. The active ETFs, meanwhile, have opted to sidestep the struggling company’s loans.

Through credit selection, the active strategies have delivered less volatility to complement the higher returns. Looking at how the funds perform in down markets, State Street’s SRLN and First Trust’s FTSL have “down-market capture ratios” of 79.01 and 58.56, respectively, compared to 104.45 for Invesco’s BKLN, according to Morningstar. A lower down-market capture ratio indicates the fund performed better.

“We are able to own better companies,” said Bill Housey, who runs the First Trust loan ETF. “In the index, these are the companies that borrowed the most money. The index makes no judgement about how much the company should borrow, which has good asset value. It tells you nothing about the company’s ability to repay that money.”

Recession Test

Of course, the true downside has yet to be tested since these funds weren’t around in the 2008 financial crisis. From the first launch of a leveraged loan ETF in 2011, default rates have remained benign. S&P Global Inc’s US speculative-grade default rate fell to 3.8 per cent in April and is projected to end 2017 at 3.9 per cent, far from default rates in excess of 10 per cent that are seen during a recession.

Still, as investment advisers like to remind their clients, past performance doesn’t guarantee future results. Indeed, judging how these funds have done in part depends on time frames. For example, although the actively managed funds have outperformed the passive ones since they were launched, looking over the past year the passive BKLN has posted a better return than the active FTSL.

“Active management has historically done well versus indexed in the loans space,” said Todd Rosenbluth, director of ETF and mutual funds at CFRA Research, an independent research provider. “But that in no way suggests that it’s going to continue to outperform because there are going to be periods where the enhanced liquidity is going to matter more.”

Whether the preference is for active or passive, leveraged loan ETFs appear poised for further growth. The debt has been popular in today’s rising rate environment, with loan funds attracting $30 billion in inflows since the middle of last year, according to Lipper Advisory Services.

Just like junk

Extrapolating from high-yield bonds, which have some similar characteristics to leveraged loans, the funds appear to have room to grow. Highland’s Chris Mawn points out that ETFs are $45 billion of the $1.3 trillion high-yield bond market. ETFs are $12.7 billion in the nearly $920 billion institutional leveraged loan market, he said.

And then there’s the funds’ ability to provide quick liquidity. It’s here that the passive vehicles may come most in handy, as both institutional and retail investors are using ETFs to get exposure to less liquid underlying assets.

Regardless, with the Federal Reserve set to raise interest rates further this year, markets should expect to see growing investor interest in loan funds.

“There are notable differences between the loan space and traditional high-yield corporates, particularly the interest rate sensitivity,” Rosenbluth said. “Loan-based products have been getting attention and are likely to get more investor attention if bond yields do go higher as the Fed takes action.”