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Fixed-Income Insights

While the low fees on high-yield bond exchange-traded funds (ETFs) seem attractive, ETFs’ approach of closely following benchmark indexes presents disadvantages.

 

In Brief

  • Low-cost investment options, such as exchange-traded funds (ETFs), seem an appealing way to potentially increase net returns in a low-yield environment.
  • But high-yield investors may wish to think twice. Many high-yield ETFs seem to offer reduced cost, yet have failed to capture the returns of benchmark indexes in recent years.
  • The problem may lie in a lack of flexibility, because ETFs tend to closely mirror the composition of indexes, which means they have similar allocations to underperforming sectors of the market. This characteristic has hurt their returns amid the slump in oil and minerals sectors, for example.
  • The key takeaway—While actively managed high-yield portfolios also have underperformed benchmarks, their greater flexibility enables managers to steer clear of sectors that may be overvalued, or may be facing difficult conditions.

 

Investors face another year of slow global economic growth and low interest rates, with the prospect of renewed market volatility compounding their concerns. While there’s not much investors can do about how those factors affect their investment returns, there is one variable that is more easily controlled: cost. Indeed, an increased focus on low-cost investment options, such as exchange-traded funds (ETFs), seems an appealing strategy to potentially increase net returns in a low-yield environment.

But a single-minded focus on cost may have its own costs. While hope for a simplistic solution is understandable, even a simple cost/benefit analysis of investments can reveal that a cost-only focus may not be in the investor’s best interest and could run counter to investment objectives. An examination of the recent performance of prominent high-yield bond ETFs demonstrates the importance of cost/benefit analysis over cost reduction when working toward net-return objectives.

In a world of low and even negative interest rates, high-yield securities may be of interest to investors who cannot find income elsewhere. Investors considering the asset class may take comfort in the growth-supportive central bank monetary policies of the European Central Bank, the Bank of Japan, and now, the U.S. Federal Reserve. Recent actions by the People’s Bank of China to prevent a “hard landing” for its nation’s economy, including tax cuts, interest-rate reductions, infrastructure spending, and programs to reduce nonperforming loans at banks, may also support investors’ decisions. The fact that high-yield spreads recently were wider than historical averages, according to JPMorgan, while 10-year U.S. Treasury securities yielded less than the rate of inflation, may further buttress the decision to add high-yield exposure.

Cost Accounting
Assuming the asset class is investor-appropriate, the key consideration centers upon the method for its inclusion in a portfolio. High-yield ETFs, like most of their open-end, high-yield mutual fund counterparts, avoid the concentrated positions that led, for example, to the closing of the Third Avenue Focused Credit Fund, along with the leverage of closed-end funds that may be inappropriate for some investors. The low-cost orientation of high-yield ETFs seems appealing, but is it truly in an investor’s interest? An examination of performance (net of fees) is likely a better consideration than focusing on fees without regard to performance.

The underlying assumption supporting ETFs is their ability to capture index performance at reduced cost.  While this may be true of some large-cap equity ETFs, leading high-yield ETFs seem to offer reduced cost, yet regularly fail to capture index returns. Two of the largest high-yield ETFs are highlighted in Table 1. The most recent net performance of each is compared to the performance of their defined benchmark for the year-to-date, one-, three-, and five-year periods.

 

Table 1. Returns of Two Major High-Yield ETFs versus Defined Benchmarks

Source: Bloomberg and Lipper. Defined benchmarks are as indicated in ETF prospectuses. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is no guarantee of future results. Performance during other time periods may differ. Due to market volatility, the market may not perform in a similar manner in the future.

 

Regardless of the holding period, the performance of the ETF fell short of the targeted benchmark in each case. Fees were controlled at 0.4–0.5% on the ETFs, compared to an average expense ratio of 1.06% on actively managed, A share high-yield mutual funds (based on a Lord Abbett analysis of Lipper category data), but persistent historical underperformance may be difficult to characterize as achieving return objectives. 

Substituting a broad category benchmark often used by actively managed high-yield funds, the BofA Merrill Lynch U.S. High Yield Master II Constrained Index, produced an even less favorable performance comparison for the ETFs.

 

Table 2. Returns of Two Major High-Yield ETFs versus a Category Benchmark

Source: Bloomberg. Category benchmarks are indexes that are widely used to compare high-yield mutual fund returns. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is no guarantee of future results. Performance during other time periods may differ. Due to market volatility, the market may not perform in a similar manner in the future.

 

This persistence of underperformance may make it difficult to justify using such an ETF as an effective way to capture return objectives, regardless of the fact that fees are relatively low.

Riding the Benchmark
What might lie behind the ETFs’ underperformance? The primary problem seems to be their need to stick close to the construction of their benchmarks. That meant that the ETFs’ holdings in the troubled energy and mining sectors mirrored those of the benchmark. That lack of flexibility meant that the ETFs were unable to overweight the debt of better managed or improving companies.

An examination of actively managed funds reveals that many times, they, too, underperform their benchmark. At the same time, history also reveals that there are managers who regularly outperform their benchmark, and outperform ETFs as well. The flexibility afforded by the active approach means that managers have the ability to steer clear of sectors that may be overvalued, or may be facing difficult conditions. It also allows managers to change portfolio weightings to favor sectors with improving fundamentals or attractive valuations. In addition, the research capabilities of active managers allow them to base investment decisions on a careful evaluation of an issuer’s financial and credit standing.

The fact that active portfolios do not have to own securities included in an index that seems positioned to perform poorly suggests that active high-yield managers may continue to have an advantage over index managers. Finding such managers may require some effort, but it seems clearly in the investor’s best interest and also a valuable service that advisors can offer to distinguish themselves among other advisors and among solutions that focus exclusively on cost. 

Summing Up
As investors seek solutions to a slow-growth, low-yield environment, focusing on one aspect of investing, such as cost, may have simplistic appeal, but ultimately may not best serve total-return objectives. Of course, investment expense should be considered carefully as a factor in an investment decision. But a more holistic approach, which factors in both an investment’s cost and the capabilities of its portfolio managers, may present a better opportunity for investors to achieve a favorable outcome.

 

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