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Market View

Here, we offer a closer look at the key attributes—and relative performance—of the two strategies.

 

In Brief

  • We think investors weighing a passive approach to gain exposure to the high-yield bond market should consider four important points.
  • First, they should note that high-yield indexes are heavily weighted to the most indebted companies.
  • Second, it is difficult for index funds and ETFs to replicate high-yield indexes.
  • A third factor to consider is that the wide dispersion of returns within the high-yield market creates opportunity for active managers.
  • The final, and perhaps most important, point: passive high-yield strategies have lagged the average active manager, with greater volatility.

 

Note: A recent white paper published on lordabbett.com compared the historical performance of active and passive investment strategies across a broad range of fixed-income sectors. Given the importance of this topic, in the coming weeks Market View will be spotlighting certain asset classes covered in the paper. Here, we feature the U.S. high-yield sector, examining the relative performance of the two approaches—as represented by exchange traded funds (ETFs) and actively managed mutual funds—and the implications for investors.

Since credit risk is a major risk to investing in U.S. high-yield bonds, one would think that an active approach to portfolio management would be most appropriate to avoid credit issues. But U.S. mutual-fund flows would seem to suggest otherwise. The contrast in flows in this $300 billion category has been dramatic, with more than $40 billion in outflows from active funds, versus nearly $18 billion in inflows to ETFs over the five years through December 31, 2017.  While these flows have been large, they also have tended to be quite erratic, especially during periods of market volatility.  For example, according to data from Lipper, over the six weeks ended February 21, 2018, high-yield ETFs suffered $6.8 billion of outflows (representing 13.6% of their assets under management).  

Before automatically allocating to passive strategies to gain exposure to the high-yield market, we would suggest that investors consider the following four points regarding passively managed vehicles, such as ETFs, and actively managed funds.

1. High-yield indexes are heavily weighted to the most indebted companies.
Major high-yield indexes feature a potential drawback that stems from the way they are structured. Within a market cap-weighted index, when companies issue more debt, they then become a larger part of the index.  As a result, a passive approach leads to larger allocations to the most indebted companies and industries.  An active manager can undertake rigorous fundamental credit research on individual issuers and choose to focus on the best opportunities, while avoiding those credits that pose the largest risk of default, or trade at unattractive valuations.

2. High-yield indexes are not easily replicated.
One reason to own an index is to gain broad exposure to an asset class. But unlike the S&P 500® Index, for example, the high-yield index is not as easily replicated. A major high-yield benchmark, the ICE BofAML U.S. High Yield Index, is a broad index that includes approximately 2,000 issues, representing a market value of $1.3 trillion. In the case of the two largest high-yield index ETFs, they instead attempt to track indexes that represent a portion of the market—the “highly liquid” market—representing the largest borrowers in high yield.

These more narrow indexes have lagged the broader higher-yield market, while generating higher volatility (see Chart 1). An active approach provides flexibility to take advantage of all market opportunities across a broader universe, not just the largest issuers of debt, while mitigating risk.

 

Chart 1. Historically, the High-Yield Market Has Generated Higher Returns Than the More Narrow Indexes Tracked by ETFs
Data as of January 31, 2018

Source: Morningstar.
Past performance is not a reliable indicator or guarantee of future results.  The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

3. The wide dispersion of returns within the high-yield market creates opportunity for active managers.
The data in Table 1 indicate that it is common to have a large dispersion of returns by rating and sector in each calendar year in the broad high-yield market (as represented by the ICE BofAML U.S. High Yield Constrained Index). An active portfolio can favor those industries that are better positioned for the economic environment, while adjusting overall risk exposure across the credit-rating spectrum. This potential advantage was evident during the commodity price collapse of 2014–15, when the energy sector, which grew to become one of the largest sectors in the major high-yield indexes, suffered sharp price declines.

For example, in the “risk-off” environment of 2014–15, ‘CCC’ rated bonds underperformed those rated ‘BB’ by 790 basis points (bps) and 1,400 bps, respectively, only to outperform by more than 2,300 bps during the recovery of 2016. A review of returns by sector in the ICE BofAML U.S. High Yield [Constrained] Index reveals a spread of more than 30% in the return of the best and worst sectors in the index. This variability creates opportunity for those managers with advanced credit analysis and security valuation capabilities.

 

Table 1.  The Wide Dispersion of Returns Creates Opportunities for Active Managers
Dispersion of returns, by credit rating and industry

Source:  BofA Merrill Lynch. Data for calendar years (ended December 31). *ICE BofAML U.S. High Yield Constrained Index.
Past performance is not a reliable indicator or guarantee of future results.  The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

4. Passive strategies have lagged the average active manager, with greater volatility.
The two large high-yield ETFs mentioned earlier have the benefit of lower expenses, but that has led to high opportunity cost. Investors focused solely on these ETFs’ low fees would have realized returns that lagged the mutual fund category average by a significant margin, placing them in the bottom third of the category over the past three-, five-, and 10-year periods. Some investors may be willing to accept lower returns if it comes with lower volatility. But in this case, these ETFs have delivered lower returns with higher volatility than the category-average manager (see Chart 2). (For a deeper look at relative performance, including the differential in dollar terms, read the full white paper.)

 

Chart 2.  Major High-Yield Bond ETFs Have Underperformed the Morningstar High-Yield Category
Trailing three-year return and standard deviation, as of January 31, 2018

Source: Morningstar performance and rankings. 1iShares iBoxx $ High Yield Corporate Bond ETF (HYG). 2SPDR Bloomberg Barclays High Yield Bond ETF (JNK).
Percentile rankings in Morningstar High Yield category (as of January 31, 2018):  iShares iBoxx $ High Yield Corporate Bond ETF rankings: one year, 65% (464/712); three years, 80% (528/658); five years, 70% (418/594); 10 years, 70% (354/471). SPDR Bloomberg Barclays High Yield Bond ETF (JNK) rankings: one year, 60% (426/712); three years, 85% (561/658); five years, 81% (481/594); 10 years, 78% (371/471). Morningstar rankings reflect all share classes within the category and are based on total return and do not reflect the effect of sales charges.
Performance quoted above is historical. Past performance is not a reliable indicator or guarantee of future results. 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. Investor may experience different results. Due to market volatility, the market may not perform in a similar manner in the future. Indexes are unmanaged. Do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

Final Thoughts
There are many nuances to consider when comparing active and passive managers, whether in high yield or other fixed-income sectors. For example, stacking up the largest ETF against the broad mutual-fund category might not be a direct comparison, since some managers may take a more flexible approach than the largest index ETF in each category

But we would encourage investors to undertake an unbiased side-by-side performance comparison of active and passive strategies.  It should not be just a question of active versus passive; rather, a better question may be to ask, “Which high-yield strategy can deliver more attractive risk-adjusted returns, after expenses, to investors?”  A review of historical performance would suggest that passive ETFs have not delivered the optimal performance experience to investors. High-yield investors who had heretofore only considered passive vehicles may be surprised—and pleased—to discover the performance attributes of actively managed strategies.

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

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