On the Fritz

Problem: High-yield bond manager Cara Vann currently holds no debt of Ratchetdown Inc. The company’s ratio of debt to cash flow is worrisomely high. Over the long run, its competitive position is eroding and analysts have raised questions about the reliability of its financial reporting. Prevailing yields on Ratchetdown’s outstanding bonds do not appear to reflect these risks fully. What should Vann do?

Solution: Buy Ratchetdown debt in an amount that equates its weight in the portfolio equivalent to the issuer’s 2% weight in the high yield index. Portfolio manager Vann cannot afford to be without exposure to a name that represents such a large portion of the benchmark. If the high-yield asset class experiences a sudden acceleration of capital inflows, lower-tier credits such as Ratchetdown will probably outperform the index. Under such circumstances, underwriters cannot immediately produce enough new issuance to absorb the new cash. Portfolio managers consequently put the money to work in names that they previously shunned. By owning Ratchetdown paper, Vann avoids the risk of having no stake in one of the period’s best-performing names.

To be sure, Ratchetdown is a weak credit that could easily go the other way. That represents no great worry, however. If the name underperforms, Vann will do no worse than other managers in her peer group, who also have 2% weightings in Ratchetdown. As long as everybody sticks reasonably close to the benchmark, it seems, nobody runs the risk of underperforming dramatically.

Please note that the solution above is not the author’s actual recommended solution. Rather, it is the approach most consistent with a strategy known as “closet indexing.” Mimicking the composition of the total return benchmark helps the manager retain clients by avoiding gross underperformance, albeit at the cost of precluding significantly higher-than-benchmark performance.

Brokerage houses that provide indices likewise benefit from closet indexing. Portfolio managers who cleave closely to the index must keep in close touch with the index’s overseer about pending additions and substitutions of issues. Constant communication on such matters leads to secondary market transactions for the brokers who supply this important information.

In short, closet indexing is good for money managers and good for dealers. To quote an old Wall Street saw, “Two out of three ain’t bad.” The only party that gets hurt is the client.

Closet indexing works contrary to the client’s interest in two ways: it precludes the possibility of performing substantially better than the index; and it essentially provides passive management under the guise of — and more important, with the fee structure of — active management. Indexed management can be implemented with fewer costs than an attempt to beat the market because it requires no credit analysts or systems for determining relative value. Charging a customary high yield fee for a disguised index portfolio is like charging a Mercedes price and putting a Volkswagen engine under the hood.

Unfortunately, many clients facilitate their own victimization. In performance reviews, they fault managers for failing to own the index’s best-performing names. That sort of feedback is yet another incentive to ape the benchmark. A wiser approach is to let the managers pursue value wherever they see it, and then judge them on their results.

Martin Fridson is a veteran of high-yield analysis and the founder of FridsonVision, an independent provider of high-yield research (www.leverageworld.com).

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