Investors were recently hit by a number of outsized moves in preferreds such as the Altera Infrastructure preferreds (down about 2/3) and Hoegh LNG preferred (down about 20%, common is down about 70%). Altera (former Teekay Offshore) has been struggling for a long time with Brookfield not having an easy time turning it around. HMLP is having issues with an Indonesian asset that makes up a big chunk of its earnings so a failure to refinance it will present major challenges for the company. In an environment of strong macro growth it may be surprising to see such major hiccups. However, this dynamic highlights the difference between systemic and idiosyncratic portfolio risks. Systemic risks are due to broader macro developments while idiosyncratic risks are, well, standalone and hard to anticipate. From the price action it was obvious that the market had no inkling about either one of these two events.

The key point for investors is that systemic risks are somewhat quantifiable – we have historic records of macro and asset class performance for more than a century for some asset classes and we also have much better intuition about how various asset classes will respond in a given market environment. In other words, it’s hard to imagine waking up one day and seeing the high-yield corporate bond space down 20% in the absence of any major macro news and no ructions in any other sector. 

Obviously, the two types of risks are not entirely distinct. A systemically poor market environment is likely to drive an increase in negative idiosyncratic events and a basket of 100 idiosyncratic positions starts to look like a portfolio that has little idiosyncratic movement and one that just reflects the broader systemic environment. 

That said, the distinction is still an important one from a portfolio allocation perspective. Market securities can be, roughly speaking, divided into idiosyncratic and systemic. Single-issuer securities e.g. common stock, preferreds or bonds of “real” companies are in the idiosyncratic camp and securities (common, preferreds and debt) of investment companies i.e. companies that hold a bunch of positions such as mutual funds, ETFs, CEFs, mortgage REITs, BDCs etc. are in the systemic camp. Again, there isn’t black and white here – some fund companies are more or less diversified and have more or less risky allocations. 

The key point here is that in a world that is essentially unchanged, an investment company such as an ETF, CEF or even mREITs or BDCs are pretty unlikely to see a 20% drawdown in an environment where not much has happened, either in its own sector or in the broader macro space. For an idiosyncratic company, such events happen all the time – a single contract dispute, a single unforeseen event, a single accident can blow up an already weak company. This doesn’t mean it’s wrong to hold idiosyncratic positions – it just means that investors need to have a higher level of conviction in those idiosyncratic positions, particularly when running undiversified portfolios. 

A simple portfolio matrix looks like the following. Investor can hold either diversified or undiversified portfolios allocated to idiosyncratic and systemic positions. A diversified portfolio of systemic positions is going to hold few surprises while an undiversified portfolio of idiosyncratic positions could hold many surprises (both bad and good). Most investors will have both idiosyncratic and systemic positions in their portfolios and will vary along the diversified / undiversified spectrum. Each investor is different and there is no right or wrong here. Someone with a background in oil will probably be quite happy holding a handful of upstream producers, another investor with a pharma background may hold a few biotech firms. And that’s all fine. The problem potentially arises when an investor is spread out in a few idiosyncratic positions that are far from “home base”. 

The key point here is that it’s tricky being knowledgeable about sectors like shipping and LNG terminals, particularly when so much happens behind the scenes. More systemic holdings like mortgage REITs (portfolios of mortgages), BDCs (portfolios of corporate loans), funds (portfolios of securities in a given sector, usually) carry much less idiosyncratic risk. The downside, of course, is that there are fewer systemic securities. However, you, obviously, don’t need as many systemic holdings to “sleep at night” than you do of idiosyncratic securities. 

Ultimately, investing is about gauging risk and reward. It’s fair to say that the risk side of the equation is much more difficult to gauge for idiosyncratic securities. To have sufficient confidence about whether Altera or HMLP will be money good just about requires a seat at the table with Brookfield managers or the HMLP Indonesian counterparty which is not even the kind of transparency that the hedgies get. These two stories could very well be money-good but the going has probably gotten a bit uncomfortable for a few holders. Systemic securities don’t demand the same kind of deep insight into individual situations (which may not be possible to gain anyway) but a broad understanding of the mechanics of the asset class, its historical behavior in various market outcomes as well as its likely dynamics over the medium term.

The key question for income investors is one of epistemology – what is knowable with any degree of confidence? How much confidence can investors have about a given┬ácompany’s ability to refinance an Indonesian credit facility versus how a particular sector or asset class will behave in a particular market environment? In a diversified portfolio, idiosyncratic events aren’t going to move the needle a whole lot. However, in a less-than-diversified portfolios they can be difficult to manage – do you double-down, hold, or sell? Drawdowns of systemic securities are less “surprising”, where history is a better guide for allocation decisions and where a sufficient level of knowledge of how to respond to events is attainable.

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