The Case Against Junk-Bond ETFs Where Managers Rout Indexesby
Over 80 percent of managed high-yield funds trump largest ETF
ETF liquidity a feature investors are willing to pay for
Tired of your stock manager? No problem, buy an exchange-traded fund that tracks the S&P 500. But if you’re sick of your junk-bond manager, good luck finding an ETF that can beat him.
Since 2007, more than 80 percent of active high-yield managers tracked by Bloomberg posted better returns than either BlackRock Inc.’s $15.9 billion iShares iBoxx $ High Yield Corporate Bond ETF or State Street Corp.’s $11.3 billion SPDR Barclays High Yield Bond ETF, the two biggest of their kind. In stocks, fewer than 25 percent of managers beat indexes over the same time frame.
Why active managers do better in junk is a pressing question for investors who’ve poured $61 billion into bond ETFs in 2016. One reason is scarcity: unlike stocks, where there’s an ETF for every style, the high-yield market offers far fewer options. Another is the challenge of building indexes in fixed income that provide enough liquidity to keep ETFs afloat.
Junk-bond ETFs are “a terrible vehicle to accumulate wealth over time,” said Gershon Distenfeld, director of high-yield at AllianceBernstein Holding LP, which oversees $35 billion. “The facts are the facts.”
Distenfeld, who’s the manager of several active credit funds, is an outspoken critic of passive junk-bond investments. But he has data to back up his claims: Since the beginning of 2008, more than 90 percent of active high-yield managers tracked by Morningstar Inc. have posted better returns than the average junk-bond ETF, while in equities just 20 percent of active managers win. BlackRock notes that over the past five years its ETF has outperformed roughly half of all active funds in all share classes.
Nobody is saying the challenges of bond ETFs automatically make them an inferior investment. If junk bonds rise, owning high-yield debt will make you money regardless of the wrapper, and not everyone who owns a junk ETF is looking to beat active managers. According to BlackRock, the percentage of active managers beating their ETF is lower when all mutual fund share classes are considered and their security has had long stretches of outperformance.
“If you don’t like it, don’t buy it,” said Oleg Melentyev, head of U.S. credit strategy at Deutsche Bank AG. “Nobody’s forcing you.”
People are buying, nevertheless. On June 24 alone, as Brexit angst swamped markets, investors directed $291 million into BlackRock’s junk ETF, more than any of the investment giant’s other ETFs, data compiled by Bloomberg show.
“An ETF sort of acts like an exchange for bonds now, because over the counter is less desirable,” said Eric Balchunas, a Bloomberg Intelligence analyst. “So now you have bonds trading in a stock-like wrapper. No shocker, it’s a huge hit.”
This year, the Lord Abbett High-Yield Fund is returning 8.1 percent, beating both ETFs but trailing its benchmark, the BofA Merrill Lynch US High-Yield Constrained Index. The Federated Institutional High-Yield Bond Fund, which uses the Barclays US High-Yield Unhedged USD Index as its benchmark, is also outperforming the ETFs with 8.7 percent returns and losing to its benchmark.
As is often true with bonds, liquidity, or the ease with which something can be bought and sold, is a central consideration in junk ETFs. The things that let you trade ETFs like stocks in real time require rapid-fire buying and selling of the underlying assets, processes that get harder the less liquid those assets are. As a result, the big junk ETFs track collections of very liquid bonds -- and those aren’t always the best-performing ones.
Ease Of Use
Losing to active managers should be viewed as the price you pay for an ETF’s ease of use, according to Melentyev. While a sophisticated stock investor has a host of alternatives for gaining passive exposure such as futures or simply buying all the stocks individually, that’s not true in credit. The need to own bonds that can be bought and sold quickly can hurt ETF returns while still being a convenience worth paying for, he said.
“What an ETF does in credit is more than just delivering you passive performance. It actually delivers you the ability to trade an illiquid market in a relatively liquid fashion,” he said. “Nothing comes free in this world, so that ability that ETF delivers to you comes at a cost.”
Pitting active managers against exchange-traded funds is a “false comparison” because of the different makeup of their portfolios, according to Steve Laipply, a strategist at BlackRock, which oversees the largest junk ETF. The Lord Abbett High Yield Fund, one of the largest actively managed junk funds, has almost 6 percent in equities, for example.
Junk ETFs also provide a way of insuring against performance swings among active managers, said Dave Mazza, a State Street ETF strategist. “They have some of the widest spread between those that do well and those that do poorly,” he said. “So an ETF can really help hedge those bets.”
BlackRock’s fund is market cap weighted and consists of fixed-rate corporate bonds, no more than 3 percent from a single issuer, all from developed countries and with life expectancy at issuance of 15 years or less. The portfolio is rebalanced at the end of each month and priced daily based on the consolidation of bid and ask quotes from eight contributing banks, including Barclays Plc and Goldman Sachs Group Inc.
According to the fund’s methodology document, pricing can pose a problem in times of market stress. If the index can’t determine how much a bond is currently worth, “it continues to be calculated based on the last-available price.” So if a bond plunges due to bad corporate news or in an economic upheaval, the index could suffer large tracking errors and be misleading to investors.
This methodology isn’t unique to BlackRock’s ETF, it’s the way indexed junk-bond portfolios generally operate. And it’s another challenge for passive funds to beat active managers, who have more flexibility of movement, particularly in the short-term.
This may explain why even Vanguard Group, which is known for its low-fee passive funds, doesn’t index junk bonds. The company launched its actively managed High-Yield Corporate Fund in 1978, but it has “no current plans to offer a high-yield index fund,” spokeswoman Katie Hirt wrote in an e-mail.
“There’s a reason why Vanguard doesn’t have a passive strategy in high-yield,” Distenfeld said. “They have a passive strategy in almost every asset class. It doesn’t work, you end up bleeding a lot of value over time.”
Still, that’s not to say high-yield ETFs serve no purpose. Even a critic like Distenfeld buys and sells them in his own fund to gain short-term exposure.
“They’re meant for professional investors,” he said. “But for a strategic investor to say, I’m going to put five percent of my portfolio in high-yield and I’m going to buy these ETFs -- the numbers don’t lie, they’re not a good solution for core high-yield strategic investment.”