Douglas Gimple (00:01):
Hello everyone. Welcome to another episode of Understanding Edge, brought to you by Diamond Hill. I'm Douglas Gimpel, senior portfolio specialist for fixed Income, and today I'm joined by Arthur Cheng, portfolio Manager for our core plus strategy. In today's episode, we'll learn more about Arthur and his background, discuss the high-yield markets, and celebrate the one-year anniversary of our Core plus strategy. Whether you're a regular listener or tuning in for the first time, we hope this episode offers valuable insights for you. So sit back, grab a cup of coffee or tea, and let's get started. Thank you for tuning in and I hope you enjoy this conversation with Arthur Cheng.
Hello Arthur, welcome to the podcast. We're excited to have you here.
Arthur Cheng (00:52):
Thanks for having me. Always excited to chat with you.
Douglas Gimple (00:55):
So let's start at the very beginning. Why don't you take us through your career and how it has progressed since your graduation from UCLA?
Arthur Cheng (01:04):
So I joined JP Morgan's high-yield team right out of school. Honestly, at the time I wasn't even entirely familiar with what the high-yield market was, so it was just a fortunate one of better things to have happened to me to fall into the market. At the time, JP Morgan's high yield team was almost 40 billion in a UM. And again, I didn't appreciate it at the time how big that was for the high-yield space, but it gave me a very good glimpse into what a massive scale, high-yield operation looks like. The positives and negatives that come with size and how complexity scales as you grow a number of clients. So I was on the client facing client portfolio management side of things for about a year, and then from there I transitioned over to the research team covering a number of sectors. The structure there was unique in the sense that the research analysts there functioned sort of like sector portfolio managers where we entered, we were entering trades for specific accounts, we were working with trade traders on the levels we wanted to execute at.
So it really was a unique experience and a great way to jumpstart my career. And it wasn't until I left that I fully appreciated how unique it was. There just aren't many places where a couple of years out of college you could be essentially in charge of over a billion of invested capital and that's where I met you Henry and Mark for the first time. It was a great place and I still keep in touch with a lot of my colleagues there, but after about seven years, I think I was just ready for something different. I was looking for something more entrepreneurial where I could have a bigger individual impact. And that opportunity came up with post advisory group and that took me back to Los Angeles Post was still a fairly large player in the high-yield market with around 18 billion in assets while I was there.
But what I liked about it was that it was a boutique investment manager, so it had maybe a hundred or so people and almost all of them were in the same building. So it wasn't a bunch of colleagues in different departments spread across different cities. It was an environment where everyone knew everybody and I was able to have a direct working relationship with the CIO. And more importantly, as far as the investment process goes post ran a more concentrated investment strategy and the increased level of diligence that comes with that in order to make sure you don't get too off sides on losing positions. And that was just a way of thinking about investing that resonated better with how I think about investing. So I think it was about around that time that I left for post that you, Henry and Mark had joined Diamond Hill and we kept in touch and I just felt like after seven to eight years at Post and then seven years at JP Morgan, it felt like I had formed a unique way of looking at high yield.
And the track record that I had at both of those places sort of gave me the confidence that maybe I was onto something. So it just so happened that around that same time, I think the fixed income platform here that Henry and Mark was building was really catching some momentum and they were thinking about extending the success of the core bond strategy and that it had had into the core plus space by attaching high yield. So the timing worked out for what I wanted to do and what the team wanted to do, and it was an added bonus that we'd worked together previously and I grew up in the area and the rest is history.
Douglas Gimple (05:25):
And it's interesting that you and Henry essentially came up through the same program. I mean you were both analysts on the client portfolio management side and then Henry moved over to the portfolio management side after about a year and you did the same thing.
Arthur Cheng (05:42):
Yeah, that's right. it was a great program. A lot of good candidates seem to have gone through that program.
Douglas Gimple (05:51):
Yeah, exactly right. So as you mentioned, your focus is on the high yield sector, specifically managing the allocation within the Diamond Hill core plus strategy. While you're analyzing opportunities in the high yield market, you must do so within the context of the overall portfolio, which includes treasuries, securitized, bonds, investment grade corporates. How do you interact with Mark and Henry, your co-portfolio managers on the core plus strategy as well as the analyst team as you guys are managing the portfolio?
Arthur Cheng (06:28):
I think it's helpful to give listeners a visual. So we sit in sort of almost like a trading pit where, or I dunno if it's maybe a trading pit or a circle. We're all within about 20 feet of each other. So we're digesting news in real time. We're shouting out what we're seeing in our sectors that can be comments on new deal flow, market liquidity or really any number of things. So we'll talk about something like relative value between what we're seeing on a day-to-day basis. This helps us really determine how attractive our respective sectors are. So Henry might be looking at an a BS deal, he might see that the double B trache is maybe coming at a spread of five, 500 over. Meanwhile I might be telling him that the overall high yield market is a 2 75 over and attractive double Bs are lucky to be plus 200 over.
So he can take that information and have it potentially impact his order size. Maybe he makes it bigger than he normally would. And the opposite is also true. I might be looking at a financial company that's new to the high yield market and I could be on the edge about playing the deal. I'll shout over and say, Hey, their unsecured bonds are coming at 8% and the deal is building slowly because it's a new issuer and I don't think the market quite understands it. And he can come over and say, Hey look, they're one of the biggest issuers in the securitized space. They have a strong reputation. I've known the management team for years. That pricing looks pretty cheap to me based on where the company's a BS is trading. So then I can factor that in and that little piece might be just what I needed to get comfortable with the name.
And then there are sector specific situations where we can lean on each other. Henry and the rest of the securitized team is like I had mentioned before, particularly helpful in helping me dive deeper into the financials portions of the high yield space because they've just interacted with so many of the issuers. And the reverse is starting to be true in certain areas like the enterprise fiber space where some high yield companies are starting to tap that market with fiber securitization. So where an issuer might be new to them, but I've been likewise been following them for years and maybe I know the management team as well, the private equity sponsor.
So there's definitely synergy in that way. From a portfolio construction standpoint, we manage risks at the portfolio level rather than just within our own specific sleeves, if you will. So if we take duration as an example, we are really looking for our alpha to come from our superior credit selection. So we generally make sure that we're not too off sides on duration versus the index. Now one of the nice things about managing high yield within the context of a core plus strategy is that the investment grade portion can easily dial up or down the duration and offset whatever I'm doing in high yield. So if it just so happens that I'm finding the most opportunity and mispricings in longer duration bonds, I can just freely purchase those without necessarily needing to find an offsetting shorter duration bond because Mark can go ahead and adjust the duration downwards by buying or selling securities in the investment grade book.
Douglas Gimple (10:10):
And there's a lot of debate within the team in talking about, you talked about visualizing our setup. So we're in kind of a big circle. There's a lot of debate going on right now about what to put in the middle of that circle, and there's some that argue for a table. I think you're one of those.
Arthur Cheng (10:28):
Oh, I'm big on the table.
Douglas Gimple (10:30):
And there are others that are arguing for soft seating, which I had not heard of before,
Arthur Cheng (10:34):
I'm very, very negative on the soft seating.
Douglas Gimple (10:39):
You and Dana are very against the soft seating. That's right. So remains to be seen how we end up, but that's something that in trying to fill out that space that's been going on for quite a while. So the core plus strategy is going to reach its one year anniversary in under a month now. So we're in the latter part of September, so in mid-October we're going to hit that one year anniversary. What are your thoughts on how things have gone in this first year and what are your expectations going forward?
Arthur Cheng (11:10):
I think it's gone really, really well. In many ways. A lot of what we've done is build off of the success that Henry and Mark has had with the core bond strategy, which has performed exceptionally well and is even competitive despite not having any high yield. The thought was that by adding high yield beta, which has historically generated higher returns than investment grade, and then hopefully contributing some alpha on top of that as well, that we could generate a very competitive product within the core plus space. The track record isn't long, but we've been able to achieve that so far and performance has been strong since inception, and this has been with the backdrop of a very impactful presidential election and drastic changes in a number of policies that initially drove, spreads a lot wider, but has since seen spreads tighten pretty drastically volatile spreads in a short time period.
They can be both a gift or a curse depending on the decisions you make. So we're fortunate that we were generally able to get through to the other side without making too many unforced errors and ending up in a pretty good shape moving forward. Hopefully we're able to do more of the same. Having a good one year number is great, but what really matters is outperforming through much longer cycles. So our investment styles have meshed well. We've generated good return so far and we've had fun while doing it, so not much more you can ask for.
Douglas Gimple (12:51):
Yeah, and coming from a guy that's been here from the beginning on the fixed income side, getting that one year under your belt is important. But as you said, continuing to deliver, I would say consistent returns is even more important. So hopefully we see the type of growth that we have seen in the other areas of fixed income and we're already seeing some of that with the core plus strategy.
Arthur Cheng (13:13):
Yeah, for sure.
Douglas Gimple (13:15):
So Arthur Diamond Hill is exploring the launch of a standalone high yield strategy in the coming months, as well as adding some support for you. Can you just walk us through what we could expect from a potential new strategy as well as plans for additional support
Arthur Cheng (13:35):
To understand how we approach high yield? I think it's instructive to build a picture of the existing high yield landscape and how many firms operate. Many of the firms, especially very large ones, they're essentially run with an index based mindset. So if a small issuer makes up three basis points in the index, then owning 10 basis points is three times market weight. So in that scenario, an analyst might have done the work and identified a good investment only for it to end up at a relatively small position size. Now on the other hand, an analyst might underwrite a company, determine it's a poor investment, but then that company makes up 200 basis points at the index so they can underweight it by owning only 75 basis points. That can put you in kind of a strange position where you might hate the bonds but still own in an absolute sense, a pretty decent sized position.
And when you manage way, you can end up with a lot of positions and performance that is sort of index like or index plus or minus. Our view is that the reality is that most bonds are fairly priced or said another way, most bonds are not interesting. So what we're looking to do is give people a way to invest in high yield, in a high impact way where every line item is adding something and cutting out all of the excess filler. So it's just going into the sectors that are most attractive, not being scared to have zero weight in the sectors. So basically run in a sector agnostic way. Now obviously there'll be guidelines in place to make sure there's adequate diversification, but what we really want is the team focused on things that only on things that matter and can truly contribute to outperformance, they should be feeling like whatever idea they're working on is the idea with the highest potential risk adjusted return.
So we're really looking to offer a best ideas portfolio with the aim of really outperforming the market in a meaningful way after fees and while we manage all the sectors or sleeves or whatever you want to call it, of core plus with the end goal of building a holistic portfolio in mind, the high yield sleeve of Core Plus has a lot of the same elements of what we're looking to offer. And so the early success of that sleeve is giving us a confidence that what we have is the right approach as far as team construction, we're looking to add two new analysts to the team dedicated solely to high yield. And we're looking for people that approach high yield in a unique way without any preconceived notions about what sectors or issuers are good or bad. And with the way that technology has progressed with the vast amounts of third party research and expert networks, AI tools, all of these things, they have increased the capacity of each individual by a lot. And the combination of these tools with thoughtfully building out a team with different skill sets and diverse viewpoints, I think you can get a lot of output while still keeping the team pretty lean.
Douglas Gimple (17:21):
So Arthur, I can't let you go without asking you about the markets, obviously. Let's talk a little bit about the high yield markets really outside of the market disruption in April and May of this year, high yield spreads have continued to grind tighter along with the other areas of the fixed income markets. As you are putting money to work, where are you finding the most attractive opportunities without getting into specific names or positions, and what would you say to that?
Arthur Cheng (17:55):
Think that high yield spreads are a bit too tight right now, sector wise, we're finding opportunities across a wide array of areas, but one specific area I'd call out is there's a decent amount of opportunity in the financial space. It's an area that's not well understood, and so we feel like it's had more than its fair share of mispricings. I've heard that some firms will boycott the sector altogether. So oftentimes financial companies issue in the securitized market way before they become issuers in the high yield market. And we're in the unique position where we can have a leg up in the underwriting process since Henry and his team of analysts have such a long history with some of these issuers. So that really helps with having developing higher conviction on the high yield side. With regard to your statement on spreads and where they're at, look, there's no denying that. We're certainly on the tighter end of history now.
There are reasons for that. The index is higher quality than it's been in the past with double Bs making up a growing share of the overall high yield market, and then the average duration of the high yield market at 2.7 years. It's the shortest it's ever been. So there are fundamentals that are underpinning these higher spreads, but I think more importantly, high yield spreads shouldn't be judged in isolation. I just read earlier this morning that the PE ratio of the s and p 500 is above 30, which is well above its historical. Average gold is at nearly $3,800 an ounce hitting record levels again. So in the context of many assets being rich to historical levels, we think high yield still offers decent value, especially if you're talking about a concentrated portfolio of best ideas. And expanding further a little bit on this last point, average spreads aren't necessarily indicative of where we are seeing opportunity.
We're looking to take concentrated bets in areas we feel are mispriced. Just yesterday, we were able to buy a double B bond with leverage of less than one times debt to EBITDA at a six and three quarter percent yield, which is higher than the entire high yield index. We've got high conviction names yielding as much as 12.5% with a spread of almost 900. Currently, we own less than a hundred positions in what I would call the plus portion, high yield of core plus compared to the broader high yield universe, which is made up of almost 2000 bonds. So the real question to us is whether we feel like we're able to search through the top 5% of risk reward ideas and come up with a compelling portfolio, and we still think we can do that. Over the past year, one of our best performing positions was actually a triple B rated bond that was trading at high yield levels and it returned 16% since October of last year. So I'd just come back around and say that big picture risk on sentiment is bidding up the prices of assets globally. High yield is certainly no exception, but fundamentals are in a good place and we're still able to be selective and find attractive ideas.
Douglas Gimple (21:29):
Alright, well Arthur, I want to thank you for joining me on the podcast. Congratulations to you and the team on the one year anniversary upcoming of the Core Plus strategy. I'm really excited to see where things head as we wrap up 2025 and we move into 2026.
Arthur Cheng (21:44):
Hey, thanks for having me. Can't wait to chat again.