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Concentrated Bond Market Brings Danger For Large Active Managers

Concentrated Bond Market Brings Danger For Large Active Managers by David Markel CFA of alephblog.

There have been a few articles recently on the underperformance of Pimco, and on the increasing concentration on the buy side of the bond market.  There is danger here for large active managers and their clients.

Two years ago, I wrote a piece called Don’t Become the Market.  Though the piece doesn’t talk about it, I wrote it partly to explain the “London Whale” problem of JPMorgan Chase & Co. (NYSE:JPM).  Anytime you become big relative to a market that you use, your own actions affect the prices of the market.  This means that a market dominated by a firm or set of firms pursuing a similar strategy will no longer be able to rely on prices as a reasonable guide in assessing risk.

Smaller players, who can trade without affecting prices, can still make their estimates of risk at current prices, and they can trade against larger players.  Though there are initially economies of scale, once you get big enough as an active investment manager, the diseconomies of scale kick in.

It is relatively easy to outperform when you are a small manager.  But when you get big as an active manager, you begin to find that you can’t find so many good investable ideas.  Now, if you were a passive manager like Vanguard, you wouldn’t have to worry — just own an even slice of everything, and complain that you don’t get a decent allocation on bond IPOs.

Because of this, I tend to use smaller managers for money that is not passively managed.  The smaller the manager, the more he can take advantage of off-the-beaten-track ideas.  If he is a trader (unlike me), being small is an advantage if he has skill.

There is an exception to this, and it is for institutions that buy and hold fixed income obligations.  In that case, holding 50% of the issue is not a problem if you’ve done your credit work right.  You have no intention of selling, and you will bear the few losses that you take.  If a large manager acts like that, it can work so long as its financing cannot run, and the defaults are not overwhelming.

My advice to readers is to use lesser-known and smaller investors if doing active investing.  If they have a a good record, use them.  You can benefit with them as they grow.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.