Hybrids: The importance of active management

BY David Bassanese | 29 November 2017
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Due to their attractive franked income returns, usually relatively low capital volatility, and ready availability through the Australian Securities Exchange (ASX), hybrid securities have been a popular choice with Australian retail investors over recent years.  That said, while until recently investing in hybrids directly was the primary method available to investors, this note outlines the many advantages of accessing this investment exposure through a managed fund structure, as provided through the recently launched BetaShares Active Australian Hybrids Fund (managed fund) (ASX Code: HBRD).

Hybrids’ unique risk-return features

Hybrid securities are neither traditional bond investments nor equities. As the name implies, they share the risk and return features of both to varying degrees, depending on the specific terms and conditions attached to the hybrid security in question. As such, and as evident in the diagram below, hybrids can be expected to produce risk and return characteristics above those of traditional fixed-income securities like bonds but below those of ordinary shares.

In the case of HBRD, for example, the Fund will target a volatility of 3% to 4% p.a., which is less than one-third of that historically displayed by the Australian equities market.  Over time, the Fund also expects to deliver net returns after fees and expenses that exceed the RBA cash rate by at least 2.5% per year.

Direct or Indirect? Why hybrids exposure through a managed fund makes sense

Historically, Australian retail investors have tended to directly buy hybrids through the ASX.  While this can be a valid investment approach, there are several advantages in accessing this investment exposure through an Active ETF such as HBRD.  I’ve detailed some of these below, however more details can be found here in a recent paper I wrote.

1. Diversification

One clear advantage of a managed fund structure is the ready diversification provided.  Due to the administrative burden of holding many securities – especially within a portfolio of other investments – it may seem practical for direct hybrid investors to own only a small number of securities, which can give rise to company-specific risk and heightened return volatility more broadly.

Indeed, as hybrids are complex securities which can differ greatly in terms of their bond and equity characteristics, diversified exposure across many securities could help mitigate this risk, as well as spread the credit risk associated with each hybrids issuer.

HBRD will aim to provide diversification through a target holding of around 20 to 50 hybrid securities when fully invested, although the actual number may vary from this target over time depending on market conditions.

2. Liquidity

Compared to the share market, the hybrids market is relatively illiquid.  As seen in the chart below, for example, the bid-offer spreads (i.e. the difference between the market price at which hybrids are able to be bought and sold) for Commonwealth Bank hybrid securities tend to be notably higher than those for its shares. What’s more, these spreads can vary greatly on a day-to-day basis – suggesting they can be highly influenced by the number of buyers and sellers on any given day.

As a result, while it’s possible for retail investors to get into and out of hybrid securities on the exchange, it can often come at a cost!  Owing to their expertise, better “buying power” through greater volumes traded, and ability to also trade directly with other financial institutions in over-the-counter (“OTC”) transactions, professional fund managers have advantages in being able to trade hybrid securities on generally better terms (i.e. tighter bid-offer spreads) than that typically faced by retail investors.

As an open-ended Active ETF, moreover, investors should be able to buy and sell units in HBRD at prices reasonably close to the Fund’s net-asset value over time  – which remains an important distinction with closed-ended listed investment companies (LICs) whose prices can often trade at discounts or premiums to NAV.

3. Downside Risk Management & Potential Alpha

Last but not least, owing to their relative complexity, probably the most critical reason to gain exposure to hybrids through a managed fund structure – and especially one that is actively managed – is to mitigate downside risk and exploit potentially greater opportunities for “market beating” alpha.

Indeed, while investors are typically well aware of the investment benefits that hybrids can offer – such as relatively high yields compared to traditional fixed-rate bonds – hybrids also carry risks which investors may be less aware of and require vigilant management.

Many investors may not able to manage the risks associated with holding hybrids due to their complexity.  While, to the untrained eye, every hybrid may appear identical, nothing could be further from the truth! Terms of issue are not uniform and often require careful analysis to properly understand – these can include terms such as bail-in provisions and non-viability clauses which, should things go downhill with a particular hybrid issuer, might create unpleasant surprises for investors.

At present, it seems that a number of investors have bought hybrid securities as a higher yielding substitute for term deposits, with franking credits.  We do not believe hybrids should be viewed in this way. And all this complexity notwithstanding, it appears that many investors continue to assess hybrids on yield alone.

In fact, properly understanding each instrument actually requires a significant amount of due diligence and expertise to assess the particular risk-return characteristics associated with individual hybrid securities.

In the case of HBRD, moreover, we have decided to launch the fund with a particular focus on risk management. Specifically, under the HBRD investment strategy, if and when the hybrids market is assessed to be overvalued or present a heightened risk of capital loss, the Fund will allocate more of its portfolio to lower risk securities (eg senior bonds) and cash.

Finally, as is the case in the small cap area of the equity market – which is also relatively inefficient – the hybrids market can also be subject to significant mispricing over time, which a diligent and skilled professional fund manager should generally be able to exploit over time.

With all the above in mind, BetaShares has decided to bring the convenience and diversification benefits of an actively managed hybrids fund to the market, with the potential for alpha and downside risk management through partnering with a skilled active manager in this space, with deep expertise in valuing, analysing and investing in hybrid securities.

Further details on the features and risks associated with the HBRD Fund are available here.

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