Harbor Capital launched its (SIHY ) last September. Earlier this year, the firm merged its existing actively managed Harbor High-Yield Bond Fund (HYFAX) into the ETF. SIHY now has assets under management of nearly $115 million. BlueCove Ltd., which takes a scientific approach to portfolio management, subadvises the Fund.
Here, VettaFi speaks with Managing Director Paul Herbert of Harbor Capital Advisors’ Investment Research Team. He explains why the issuer chose Blue Cove to manage SIHY and what sets the Fund apart from its peers.
How did you select BlueCove as the fund subadvisor? What stood out about that firm?
BlueCove initially piqued our interest because its leaders had successful experiences at other firms. They were bringing that together in a new boutique manager focused on a creative yet intuitive investing approach. This kicked off an intensive, all-hands-on-deck due diligence process. There were multiple iterations and touchpoints between Harbor and BlueCove, and Harbor and other firms.
Given how much there was to learn about the people and approach, this took a period of more than two years. In the end, a number of attractive features really came together. BlueCove offered a distinct investment approach, positioned to potentially disrupt; a built-for-purpose firm; and an experienced investment team. This all created the opportunity to partner on attractive value propositions for investors.
What makes SIHY different from passive index-based high yield ETFs? What is active scientific investing?
Let’s take the second part first. A scientific investment process is evidence-based, data-driven, economically intuitive, and grounded in the historical scientific method with targeted R&D at each step of the investment process. BlueCove applies the scientific method to accessing a broad set of data, developing/testing proprietary insights, portfolio construction, and trading. Among the benefits of a scientific process are the potential ability to generate alpha uncorrelated with markets/traditional discretionary processes.
SIHY is intentionally quite different from passive options. For example, alpha models drive the Fund’s strategy in the areas of sentiment, valuation, and fundamentals, all selected based on economic intuition and empirical efficacy. In optimization, BlueCove seeks to maximize alpha while minimizing risks from the market and similar factors, limiting issuer concentration, and minimizing transaction costs.
Importantly, to succeed, Harbor believes that active approaches must have the capacity to adapt and improve. BlueCove hard-wired its focus on improvement into its firm and process. Indeed, it has incorporated new signals and signal improvements. Passive strategies simply do not do this. We expect and have seen active exposures and excess return versus SIHY’s benchmark since inception.1
Why is active management advantageous in the high yield space? Does active management have the potential to reduce risks and/or enhance returns?
We believe active managers tend to have the skills and flexibility to select issuers with better credit profiles and construct portfolios that allocate the most to bonds with the most appealing risk/reward characteristics. As already mentioned, many passive strategies use market capitalization weighting. That means they place the greatest weight on those issuers with the most debt. Consequently, passive strategies can be more vulnerable to periods of economic stress.
Passive Investing Drawbacks
Furthermore, index funds’ rules-based approach may not allow for the flexibility required to optimally manage risk. For example, index funds may have to hold deteriorating credits as long as they remain in the index. Similarly, when a bond falls out of the index, that may force index funds to sell at an inopportune time. Often that is when liquidity is most challenged.
In contrast, active managers can try to avoid troublesome creditors in the first place. By closely monitoring portfolio holdings, active managers can strive to eliminate weakening issuers long before they are dropped from the index. Active managers like BlueCove also can time their purchases and sales to take advantage of forced sellers like index funds.
Lastly, passive investing in the high yield bond space is meaningfully different versus passive investing within equities. We attribute this to the lower liquidity and/or availability of issues for passive products to employ in their attempt to replicate broad U.S. high yield bond benchmarks.
We believe active has the potential to both reduce risks and provide attractive returns.
How is high yield positioned in the current environment? What is the outlook for this space?
BlueCove positioned SIHY defensively, given the firm’s expectations for rising corporate defaults. The subadvisor believes this will occur against a backdrop of tightening lending conditions, continuing corporate margin contractions, eroding consumer savings, sticky inflation, and elevated geopolitical risk.
BlueCove’s expectation is that further fundamental deterioration in credit quality is likely as the year progresses. This is good news for a fund such as SIHY. It seeks to differentiate itself by focusing on opportunities in security selection instead of emphasizing market directional risk.
SIHY Sector Tilts
Which industry/sectors are driving performance in high yield right now? Is SIHY overweight toward any industry/ sectors?
SIHY’s primary source of added value is security selection. For instance, if you look at sector attribution for the YTD 2023 period through June, its best relative performance has come from the energy sector. That’s despite the fact that the sector’s performance at the benchmark level has not been meaningfully better than the index’s overall performance. Instead, based on its investment process, BlueCove has allocated to companies in the sector that have outperformed.
Sector positioning relative to the benchmark may also be an additional source of excess return in 2023. The index’s top-performing sectors have been Leisure, Retail, and Technology & Electronics. SIHY has been overweight Retail and as a result, has had positive sector allocation performance from the decision.
SIHY has been overweight Retail and, as a result has had positive sector allocation performance from the decision. On the other hand, it has been underweight in Telecommunications, a sector that has underperformed this year. That sector positioning has worked out to the Fund’s advantage.
SIHY has been available to investors for nearly two years. How has it done in capturing opportunities in that time?
We’ve been very pleased with SIHY’s performance during this period. Since inception, September 2021 to June 30, 2023, it has outperformed the ICE BofA U.S. High Yield Index by 144 basis points, annualized, at NAV, after fees.
We are even more pleased that the performance has been driven by security selection. As I previously mentioned, that is consistent with what we expect. The strategy has also hedged well in periods when the index has not performed well. It has had a downside capture ratio, or statistical measure of an investment manager’s overall performance in down-markets versus the index, since inception, September 2021, of 85%.
1 Performance data shown represents past performance and does not guarantee future results. Past performance is net of management fees and expenses and reflects reinvested dividends and distributions. Past performance reflects the beneficial effect of any expense waivers or reimbursements, without which returns would have been lower. Investment returns and principal value will fluctuate and, when redeemed, may be worth more or less than their original cost. Returns for periods less than one year are not annualized. Current performance may be higher or lower and is available through the most recent month end at harborcapital.com or by calling 800-422-1050. For the most current standardized performance, holdings and current yields: SIHY
Investors should carefully consider the investment objectives, risks, charges and expenses of a fund before investing. To obtain a summary prospectus or prospectus for this and other information, visit harborcapital.com or call 800-422-1050. Read it carefully before investing. All investments involve risk including the possible loss of principal. Please refer to the Fund’s prospectus for additional risks associated with each Fund. For the most current standardized performance, holdings and current yields: SIHY
SIHY Risks: Fixed income securities fluctuate in price in response to various factors, including changes in interest rates, changes in market conditions and issuer-specific events, and the value of your investment in the Fund may go down. As interest rates rise, the values of fixed income securities held by the Fund are likely to decrease and reduce the value of the Fund’s portfolio. There is a greater risk that the Funds will lose money because they invest in below-investment grade fixed income securities and unrated securities of similar credit quality (commonly referred to as “high-yield securities” or “junk bonds”). These securities are considered speculative because they have a higher risk of issuer default, are subject to greater price volatility and may be illiquid.
Because the Funds may invest in securities of foreign issuers, an investment in the Funds is subject to special risks in addition to those of U.S. securities. These risks include heightened political and economic risks, greater volatility, currency fluctuations, higher transaction costs, delayed settlement, possible foreign controls on investment, possible sanctions by government bodies of other countries and less stringent investor protection and disclosure standards of foreign markets.
ntitative model cannot fully match the complexity of the financial markets and therefore sudden unanticipated changes in underlying market conditions can significantly impact their performance. The effectiveness of the given strategy or technique may deteriorate in an unpredictable fashion for any number of reasons including, but not limited to, an increase in the amount of assets managed or the use of similar strategies or techniques by other market participants and/or market dynamic shifts over time.
Unlike mutual funds, ETFs may trade at a premium or discount to their net asset value. The ETF is new and has limited operating history to judge.
The views expressed herein are those of Harbor Capital Advisors, Inc. investment professionals at the time the comments were made. They may not be reflective of their current opinions, are subject to change without prior notice, and should not be considered investment advice.
The SEC yield is a standard yield calculation developed by the U.S. Securities and Exchange Commission (SEC) that allows for fairer comparisons of bond funds.
30‐Day SEC yield represents net investment income earned by a fund over a 30‐day period, expressed as an annual percentage rate based on the Fund’s share price at the end of the 30‐day period.
The ICE BofA US High Yield Index (H0A0) Index is an unmanaged index that tracks the performance of below investment grade U.S. Dollar-denominated corporate bonds publicly issued in the U.S. domestic market. All bonds are U.S. dollar denominated and rated Split BBB and below. This unmanaged index does not reflect fees and expenses and is not available for direct investment.
Alpha is a measure of risk (beta)-adjusted return. Earnings per Share (EPS) is the portion of a company’s profit allocated to each outstanding share.
A basis point is one hundredth of 1 percentage point.
BlueCove is a third-party subadvisor to the Harbor Scientific Alpha High-Yield ETF, the Harbor Scientific Alpha Income ETF, and the Harbor Convertible Securities Fund.
This article was prepared as Harbor Funds paid sponsorship with VettaFI.
Foreside Fund Services, LLC is the Distributor of the Harbor ETFs.Harbor Funds Distributors, Inc. is the Distributor of the Harbor Mutual Funds.