Kevin Egan, Invesco
For most asset classes and sectors, passive exchange-traded funds (ETFs) are usually a significantly less expensive investment option, often providing risk-adjusted returns similar, if not better, than those of actively managed funds.
An exception seems to be the niche sector of syndicated bank loans.
Invesco offers the actively managed US Senior Loan Fund and the passively managed Powershares Senior Loan Portfolio, a US-listed ETF. A quick comparison shows that the active fund outperformed the passive one 11.4% to 8% over the past three years, with a lower volatility (1.89 vs. 2.23).
Moreover, while the ETF carries the expense ratio of 67 basis points, the active fund fees vary from 55 basis points for institutional class to 91 basis points for the retail share class registered for sale to investors in Singapore. Other loan ETFs on the US market — Invesco’s is the largest — charge between 55 and 88 basis points.
The fact that the ETF is not much cheaper than the active fund “speaks to the bespoke nature of the bank loan asset class,” Kevin Egan, co-head of credit research and senior portfolio manager at Invesco, told FSA. Since individuals cannot buy bank loans directly, both the ETF and the active funds carry the cost of access to the asset class.
Because the ETF doesn’t always beat the active fund on fees, and over some investment horizons may have lower returns and higher volatility, most investors who buy the ETF are probably those who are mandated to invest passively.
Senior loans (also called bank loans or syndicated loans) are an asset class akin to high yield bonds, however they represent corporate borrowing secured by assets and carry floating interest rates, typically Libor plus a credit spread. In a rising rate environment, they are likely to deliver higher coupon returns without a decline in price. FSA wrote about the asset class previously.
The Powershares ETF follows the S&P/LTSA US Leveraged Loan 100 Index and invests in the 100 largest loans in the US market, proportionally to their size.
On the other hand, the actively managed fund follows a different benchmark, the Credit Suisse Leveraged Loan Index, which contains 1,400 issues. The fund held 805 holdings from 546 issuers at the end of April, according to its factsheet.
Both the passive and active funds invest mainly in the “par market” of below-investment grade loans, as opposed to distressed loans, with the intention of collecting coupon payments until the loans mature or get refinanced.
Egan said most bank loans on the market support corporate acquisitions or leveraged buyouts by private equity firms.
The ETF is the more volatile of the two because by design it owns the larger and more liquid end of the loan market, and these loans tend to move more in price, he said.
The team managing the active loan fund is walled off from Invesco’s high yield team, according to Egan. This separation gives it better access to potential borrowers. “Loans are not securities,” he stressed.
Thanks to the different regulatory treatment of syndicated loans as opposed to high yield bonds, the loan analysts have access to material non-public information from borrowers, such as internal reports and management budgets, which provide better insight into the company than a high-yield bond manager would have.
The asset class faces two main risks. The first is a rise in defaults, which could be precipitated by an economic downturn. While handling defaults is part and parcel of managing a portfolio of non-investment grade loans, it is a time-consuming and labour-intensive process for the fund team and it eats into the fund’s returns.
The other risk is spread compression, which would result in lower returns on loans. Determined chiefly by supply and demand of loans, lower credit spreads would detract from rising interest rates, also reducing the returns. While the spreads are currently better than they were in 2016 and 2017, according to Egan, they are difficult to predict more than a few months ahead.
Invesco’s active and passive US loan funds vs category average