The incredible growth of the high yield asset class is evident through various product innovations such as high yield exchange traded funds (ETFs). Since their introduction in 2007, ETF assets have swelled to about $35 billion. The two largest, the iShares iBoxx $ High Yield Corporate Bond (HYG) and SPDR Barclays High Yield Bond (JNK) account for about two-thirds of the high yield ETFs outstanding. High yield ETFs are passively managed pools of high yield bonds designed to track an index, yet trade on exchanges, just like stocks. Their attributes include low fees, diversification, and intraday liquidity.
In concept, it sounds great – however, my colleague Matt Philo, head of MacKay Shields’ High Yield Group reminds me, high yield ETFs have repeatedly underperformed actively managed mutual funds. As of January 31, 2014, the average five year annualized return of the Morningstar US actively managed funds ETF High Yield universe was 13.99%. By comparison, the Morningstar High Yield mutual fund universe of actively managed funds returned an average of 15.18%.
Why has high yield ETF performance been so poor?
Let’s start with the inherent mismatch. Unlike stocks, in which there is a continuous market, high yield bonds trade over-the-counter, meaning that liquidity for ETF holdings can, and at times is, more constrained. In addition, ETF trading in high yield bonds is determined by flows. When demand is strong and ETFs experience inflows, the ETFs authorize market makers to buy high yield bonds in order to create new ETF shares. When ETFs experience outflows as investors pull out, the opposite occurs. Market makers are authorized to sell bonds in order to redeem existing ETF shares.
This means that ETFs are “forced” to trade, even at unfavorable prices. When demand is strong, the manager becomes an indiscriminate buyer and must put cash to work. Forced selling can be particularly harmful when prices are falling, when liquidity also often dries up. Since ETFs are generally buying in rising markets and selling in declining markets, they are basically designed to chase higher prices and drive prices lower. The market impact can be exacerbated due to the magnitude of ETF flows relative to their size. ETFs assets today represent only 12% of high yield retail assets, but their weekly flows can often represent more than 50% of total retail flows.
Also, Matt warns that once you look under the hood, you’ll notice that most high yield ETFs tend to own the same bonds. As a result, ETF flows exert a strong technical influence on these “ETF bonds”. They tend to trade at premiums to their fundamental value during periods of strong demand, and discounts during periods of outflows. These bonds also attract the interest of speculators betting on the direction of ETF flows, while longer term investors who want to avoid these technical factors may steer clear of them.
There are merits to ETFs for asset classes where the underlying beta characteristics or the index can be replicated with ease and at low cost. High yield is not one such asset class. The low fees are compelling, but it’s the net return that counts. Don’t be fooled into thinking high yield is an asset class where skill does not matter – it does! The real consideration long-term investors should make is that the lagging results have been with a backdrop of a BULL high yield market, what happens when/if the tides turn and credit analysis begins to matter? The answer: Investors will pay less in fees but be vulnerable to poor passive performance.
This material is distributed for informational purposes only. The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all MacKay Shields Portfolio Management Teams. Any forward looking statements speak only as of the date they are made, and MacKay Shields LLC assumes no duty and does not undertake to update forward looking statements.