High-yield exchange-traded funds (ETFs) have been growing like gangbusters in recent months, despite continued weak performance relative to the indices that they track. While these instruments make sense for investors who make rapid, tactical trades into and out of the asset class, we think they’re a poor choice for those seeking to gain long-term exposure to high-yield bonds. Below, my colleagues Ashish Shah and Gershon Distenfeld explain why.
Early in 2012, the steady flow of funds into the high-yield ETF market became a torrent. Although ETFs still represent just 2% of the high-yield market, about one-third of the flows into the high-yield bond market this year have gone into ETFs. What’s the appeal?
First of all, high-yield bonds themselves are attractive. With interest rates at historic lows around the developed world, there are few remaining bond sectors that still offer attractive yields. And as we’ve written before, high-yield bonds have historically offered comparable returns to equities, with about half the volatility. That’s an attractive proposition for investors looking to reduce their portfolio risk.
Second, high-yield ETFs appear to offer a convenient vehicle for exploiting this opportunity. ETFs in and of themselves are relatively liquid. Unlike mutual funds, which are priced just once a day, ETFs are traded on exchanges and thus can be bought or sold at any time, just like stocks. Also, management fees for ETFs are lower than for actively managed mutual funds—and even for passively managed mutual funds.
Since the existing high-yield ETFs are index funds, investors see them as an easy and efficient way to gain exposure to the asset class, much as they might use an ETF to represent the S&P 500 Index or US Treasuries. Thus, many investment advisors use ETFs as core holdings in their clients’ portfolios. The problem is, high-yield ETFs haven’t done a very good job of tracking benchmark indices.
In fact, high-yield ETFs have significantly underperformed since 2007, when the market for them first took off. An asset-weighted composite of the two largest high-yield funds, JNK and HYG—which together now comprise roughly 90% of all assets in the high-yield ETF marketplace—has delivered an annualized return of 6.4% since the end of 2007. That’s well short of the 10.0% annualized return for the Barclays Capital US High Yield Very Liquid Index. The performance gap has steadily widened over the last three years, as the high-yield market has enjoyed its biggest rally on record, as the Display below shows.
What’s the source of this underperformance? A high-yield ETF isn’t like an ETF tracking the S&P 500 or US Treasuries. Bonds go into and out of the high-yield benchmarks far more often than stocks go into and out of the S&P 500, so ETF managers are forced to trade more in the high-yield bonds that make up the index.
And unlike most large-cap stocks or US Treasuries, many high-yield bonds are very illiquid. Specific bonds often trade infrequently, and transaction costs can be high. Bid/ask spreads typically range from 0.75% to 1% in the high-yield market, but sometimes go as high as 2%. That’s far higher than a typical bid/ask spread of less than 0.01% for Treasuries and 0.03% to 0.04% for the components of the S&P 500.
Of course, high turnover and transaction costs can be an issue for high-yield mutual funds, too—and high-yield mutual funds, on average, have also underperformed the index, but by less. Hefty flows into and out of ETFs (they have represented over 50% of the trading in high-yield cash bonds year to date) mean that such costs can mount more quickly for ETFs, eroding returns to investors in these instruments.
Furthermore, there is significant dispersion in the results for actively managed high-yield mutual funds that data on average performance masks. Investors have the opportunity to gain higher performance by picking a skilled active manager. They don’t have the same opportunity with high-yield ETFs, because there’s less dispersion in the results.
In addition, popular high-yield ETFs tend to trade at a premium to their net asset value (NAV), due to large inflows based on strong appetite for yield among retail investors. In theory, this shouldn’t last long. When a closed-end fund trades above NAV, market makers usually sell shares in the fund and buy the cheaper underlying securities. The same arbitrage process occurs with ETFs, and usually helps keep ETF market prices in line with their underlying value.
But in illiquid markets such as high yield, the arbitrage process tends to break down. It’s simply too hard for traders to gain access to the underlying securities. The end result is that high-yield ETF investors overpay for the underlying investments.
To be sure, ETFs are useful instruments for short-term trading. But in illiquid markets such as high yield, we think they’re a poor solution for investors seeking longer-term exposure to an asset class. In such cases, we think the odds are greater that a skillful active manager will outperform over a full market cycle. In our view, investors would be better off selecting a well-managed mutual fund.
For more on this topic, see "Beware Costs, Underperformance in High Yield ETFs," which
Michael Aneiro wrote for Barron's after interviewing Gershon Distenfeld.
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