Given recent volatility in high-yield markets, investors might want to look through the potential window of opportunity from a different angle. Understanding the “active risk” in high-yield portfolios — including both systematic factors and idiosyncratic security-specific risk — provides a view into how risk-adjusted returns are generated over a full market cycle.
Traditionally, fixed-income investors have focused on tracking error, which looks at a portfolio's standard deviation from a benchmark, to measure the relative risk of a strategy. For active high-yield strategies, however, tracking error does not always provide a complete picture of the embedded risks within a portfolio because it is largely driven by systematic differences between the portfolio and its benchmark.
High-yield managers are typically more focused on driving returns from superior security selection; consequently, they emphasize credit-specific risk and seek to minimize systematic factors or market risk. This can result in muted tracking error, creating a perception that the manager is not taking sufficient active risk relative to the benchmark. However, as we have seen recently, security-specific risks can be a significant driver of returns in high yield, particularly in times of heightened volatility. So how can investors accurately assess these idiosyncratic risks within a portfolio?
In recent years, the concept of active share, the degree to which a portfolio's holdings differ from its benchmark, has been applied to equity portfolios. In our view, it can also provide valuable insights on the drivers of risk and performance in fixed income, particularly in high-yield strategies. In contrast to tracking error, active share more directly captures the differences between a portfolio and a benchmark at the security level for a credit-oriented manager.
But active share is somewhat different in its application to fixed income vs. equity portfolios. For example, we might expect active share to be lower in high yield than in equity portfolios, given the asymmetric nature and negative skew of fixed-income returns. In the best-case scenario, an investor's principal is returned at maturity, along with the promised yield on the bond; in the worst case, the issuer defaults and the investor receives only a percentage of the principal due or is not repaid at all. This return asymmetry argues for broader diversification within high yield, while still maintaining an excellent assessment of active risk taking and security selection skills.
The question, then, is how can fixed-income managers calibrate a reasonable level of active share in a high-yield portfolio? They must consider not only the underlying benchmark, but also the degree to which their investment and risk oversight process allows them to underweight large benchmark names. The more concentrated the benchmark and the more constraints placed on the portfolio construction process relative to the benchmark, the harder it is to achieve a high active share.
Applying active share to fixed-income portfolios introduces other complexities not encountered in equities, such as whether to measure exposure at the issue or issuer level, as well as maturity structure and spread duration differences within an issuer's capital structure. For instance, active share at the issue level will be higher than at the issuer level because the same issuer could have multiple bonds with different maturities, interest rates and coupon payments. That said, default risk and realized credit loss remain the primary drivers of long-term, risk-adjusted returns in high yield, so active share at the issuer level should be the primary driver of long-term performance.
