The active versus passive investing debate has been a recurring event ever since the launch of the first exchange-traded funds. As a low-cost, index-tracking alternative to active funds, passives have been gaining in popularity across all asset classes.
In the high-yield bond area, passive solutions in the EUR high-yield bond and USD high-yield bond Morningstar Categories already have market shares of 15% and 11%, respectively. In both cases, iShares is the dominant provider, with the iShares € High Yield Corporate Bond ETF (IHYG) and the iShares $ High Yield Corporate Bond ETF (HYG) trumping all other competing ETFs by a large margin in terms of assets under management and pertaining to the largest funds in their respective categories.
Do High Yield Bond ETFs Deliver?
Against a backdrop of increased popularity, it becomes important to assess if high-yield ETFs truly are the efficient alternative to active funds that many investors hold them to be. For example, how feasible is it to replicate the high-yield market and passively track it? And more important, can a passive approach to high yield deliver excess returns over active peers in the long term?
For this analysis, we’ll focus on the two market-leading iShares ETFs as they also have the longest track records. The iShares € High Yield Corporate Bond ETF has performed below average when compared with the EUR High Yield Bond Morningstar Category, which consists of both passive and active funds, but is dominated by the latter.
Over trailing one-, three-, and five-year periods, the ETF consistently lands in the third performance quintile. Meanwhile, compared with the USD high-yield bond category average, the iShares $ High Yield Corporate Bond ETF also consistently lands in the third return quintile, but performance is more in line with the category average. However, on a risk-adjusted basis, as measured by Sharpe ratio, both ETFs consistently lag their category averages.
What is the Cost of These Investments?
Both ETFs come with an ongoing charge of 0.5%. Although not the cheapest passive options, they’re nonetheless priced competitively against the average active fund in their categories.
Additional costs borne by investors but not included in the ongoing charge include bid/offer spreads and brokerage fees when buy/sell orders are placed for ETF shares. Turnover ratios are a measure of a fund’s trading activity and thus provide a good proxy for transaction costs. As turnover ratios are generally hard to come by for Europe-domiciled funds, we have looked at US-domiciled ETFs instead and found turnover ratios for the largest high-yield bond ETFs to be considerably lower than the category averages over the years.
High-Yield Bond ETFs Have Lagged
The generally illiquid nature of the high-yield bond market has created important replication challenges for passive funds. Some of these issues have been partly addressed at index level by focusing on the most liquid parts of the underlying. Generally, these are bonds issued by the largest corporations in the high-yield bond space.
For example, the Markit iBoxx USD Liquid High Yield Bond Index, tracked by the iShares $ High Yield Bond ETF, requires bonds to have a minimum outstanding of $400 million. This has facilitated replication – particularly for passive funds employing physical replication – and improved tracking ability. However, the focus on liquidity has come with an obvious downside, namely that of not providing a comprehensive representation of the market. In addition to focusing on liquidity, some high-yield bond benchmarks go a step further and exclude the riskiest segment of the market from a legal standpoint, unsubordinated debt.
This may appeal to the most risk-averse investors but also contribute to making benchmarks less representative of the true nature of the underlying. Ultimately, this means that high-yield bond passive funds fall way short of mirroring how active managers position themselves in this space. As a result, experienced and well-informed active managers can successfully exploit the opportunities overlooked by indexes to add value – for example, by tapping into the smaller-cap or riskiest spectrum of the issuer universe and thus boosting the overall yield-generating potential of the portfolio.
Which Active Funds Favourably Compare?
A good example of this is Gold-rated Robeco High Yield Bonds, which actively allocates to the mid- and small-cap segment.
High-yield bond ETFs do what they’re supposed to do –t hat is, faithfully track their benchmark–and investors simply seeking a low-cost passive solution to gain fast access to the market could be well served by them.
ETFs have also become a useful price-discovery mechanism for this notoriously opaque corner of the fixed-income market. Ultimately, however, this is an area where the value of information and the flexibility of a nonbenchmark-tied mandate seem to provide a clear edge, which is why the largest high-yield bond passive funds in the EUR and USD high-yield Morningstar Categories are awarded Morningstar Analyst Ratings of Neutral.
