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2

Where Active Finds Opportunities

2. Where Active Finds Opportunities

At the heart of active management is the concept that markets are not always perfectly efficient. Market inefficiencies can and do occur wherever there are asymmetries in available information, or behavioral differences among investors. While the primary concern over active management is that markets tend to be efficient, there are multiple factors in the fixed income markets that can lead to inefficiency:

Investment restrictions
Large investors such as banks, pension funds, and insurance companies may buy securities based on restrictions for allowable credit ratings or regulatory considerations, where valuations are only a secondary consideration.

Credit ratings
Many investment entities are constrained by internal investment guidelines to purchase only securities with certain credit ratings, or to keep a certain amount of assets invested in U.S. Treasuries, regardless of valuations.   

Central bank activity
The U.S. Federal Reserve’s decision to buy large amounts of U.S. Treasury and agency bonds under its quantitative easing program resulted in significant distortions in the fixed-income market, with a marked impact on relative valuations.

Regulatory changes
With the advent of money-market reform in 2016, an abrupt shift in demand for shorter-term bonds caused certain corporate bond issues to trade with wider spreads on their short-term debt than on their longer term debt.  Dodd-Frank shifted bank demand for treasuries and mortgages.  Such examples may happen frequently, if on a smaller scale that many investors may not notice.

Benchmarks
Major indexes may make compositional changes based only on an arbitrary determination of whether a security is in or out of the benchmark, rather than valuation. This is another potential source of inefficiency.

Despite the widespread existence of pricing inefficiencies—the key ingredient for active management—detractors frequently claim that any manager success in monetizing these inefficiencies comes from luck, not skill.  They point to aggregate active results, which, when averaged, often fail to beat various indexes.  If active management truly added value, the thought goes, then the average performance of active managers should exceed that of passive options – the total market should be thought of as a zero-sum game.

While this argument ignores the fact that many strategies have different goals, so that aggregate success can’t simply be thought of as “did the collective outperform the market”, it highlights an important issue: If a manager outperforms, is it luck or skill?  There will always be some element of randomness in future events, thus some element of luck in short term returns.

In our view, an effective active manager endeavors to reduce the impact of luck on each specific investment.  To do that, we want to consider how many variables can impact the outcome of our investment, and try to reduce them, while focusing on areas where skill can exist and make a difference.  For example, instead of making an outright bet on the overall direction of interest rates (an efficient and highly scrutinized market), we will look at how similar securities compare to one another in terms of valuation. Or maybe instead of thinking that a cruise operator looks “cheap”, thus the price should go up (while being vulnerable to a host of unrelated factors, such as oil prices or the global economy), we consider it relative to a competitor; that way, our sensitivity to those less predictable variables can be reduced.

We can call this type of investment in general “relative value.”  What we are really trying to do with this type of investment is isolating the impact of our analytical skill, and reducing the impact of luck on the overall outcome.  We believe relative value assessments are at the heart of any successful actively managed strategy because they can mitigate the impact of luck and identify price assymetries.

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