@Catalin Pateo
Eric Golberg: Fallen angels are most viable as investments when there is a clear hypothesis on what caused the security to fall in the first place.
This requires a clear definition of “fallen”. For example, was the security sold off due to a general sell off in the industry or sector? Or was there some specific reason why that security was sold off?
Often, these securities sell off for very good company specific reasons rather than technical market sell off reasons. The junior tranches of CMBS, hotel MBS and higher risk CLO equity tranches are good examples, as their prices have fallen for good reason.
"To successfully invest in fallen angels requires industry expertise
and a disciplined and consistent investment process."
It is also important to define “angel”. Was the company or issuer a leader in its industry as many times these angels are not angels at all and are sick companies that need restructuring.
Note that Warren Buffet will often add to securities in his portfolio after they have sold off and this is not simply because he claims to be a long-term investor, he has also exited positions after they have sold off. Rather, he seems to add to management teams and industries that he likes and has followed for many years.
To successfully invest in fallen angels requires industry expertise and a disciplined and consistent investment process. The investment hypothesis also needs to include factors to monitor scenarios that will indicate when the hypothesis is incorrect.
Eric: One important risk monitoring strategy is determining what developments will indicate that one’s fallen angel hypothesis on a security is frankly wrong.
Some basic money management strategies from the trading world can be useful. For instance, if the hypothesis is that the investment will return 20% in over a certain number of years, how much downside loss is one willing to risk in order to achieve that return and what is the plan or strategy when that loss level is reached?
"It is important to think about fallen angels and distressed securities,
as they require different approaches."
One should also consider the relative illiquidity of fallen angel securities, as the chances are that if one’s loss limit is reached or the hypothesis is simply incorrect, exiting the position will be very painful.
One may also want to consider a strategy of taking profit on part of the position if the return target is reached prior to the end of the expected investment period. It is also important to think about fallen angels and distressed securities, as they require different approaches.
Distressed investment is a strategy in itself, but one has to be clear if one is investing for control by taking a company through bankruptcy and exiting, or investing for a certain time period and hoping to exit - as they are two very different strategies.
Eric: One needs to include the ability or mandate to buy new positions or add to current positions after a sell off, as this is an important strategic tool. Many firms don’t have this explicit mandate or flexibility and so can’t act quickly enough.
One should also have a clear investment process and risk budget in place for these opportunities and also understand that this is not a short-term market timing procedure or operation.
Many have noted that for the last three years, we have been in an environment that features relatively unpredictable sharp equity market sell offs that are often due to market structure and liquidity reasons more than security or company specific reasons. You need to be aware of this and have, as a strategic tool, a hypothesis that this environment will continue, and you want to take advantage of it.
"Many firms don’t have this explicit mandate or flexibility
and so can’t act quickly enough."
One strategic tool to help identify and take advantage of mispricing’s is to monitor the volatility markets or invest in a volatility relative value manager with strong research and risk controls, who will share their outlook in more detail.
Another strategic tool is to note that often other markets are led by what happens in the equity market, particularly in sell offs that reduce liquidity. An example of this is when equity markets selloff, often the structured credit or high yield markets will sell off. So, be prepared that an equity market sell off can be a signal that it is time to look for mispricing’s in other asset classes.
An important strategic tool is patience and discipline that stops one from chasing yield and returns in the first place. We saw a lot of yield chasing in 2019, which almost seemed to set up market selloffs in 2020 even if the pandemic had not occurred.
"Markets are led by what happens in the equity market,
particularly in sell offs that reduce liquidity."
As a strategy it is also worth noting that the better hedge fund managers have a list of securities that they are prepared to buy during or after a selloff. Asset managers and allocators can use a similar approach by preparing to invest before the selloff.
Some investors and allocators like the optionality of cash, which is having cash in hand and earmarked for investment after a selloff. One does need to be able to move quickly with this strategy as prices can snap back quickly. Also, there is the reality that holding assets in cash can be a drag on returns given the low interest rates.
Those who simply take the view that they are long term investors and their hypothesis is that the market will always be higher in the long term, who choose to mainly invest in passive vehicles, will simply not have the strategic tools to identify and take advantage of mispricing.
