Kames Capital has written a paper which claims that there are three reasons high yield bond ETFs are failing to deliver market returns.
The firm writes that April 2017 saw the 10-year anniversary of the largest US high yield bond ETF, which delivered total returns of 70.8 per cent or 5.5 per cent per annum over the period.
While those returns appear reasonable at first glance, Stephen Baines, co-manager of the Kames Short Dated High Yield Global Bond Fund, says they ‘look somewhat disappointing’ when compared to the broad high yield market, which returned 105 per cent cumulative (7.4 per cent per annum) over the same timeframe.
“Firstly, unlike most equity ETFs which are available for a few basis points, the leading high yield bond ETFs charge management fees which are comparable to many actively managed funds,” Baines writes.
“Secondly, unlike an equity index which is relatively static, the entire high yield bond market rapidly turns over as bonds are issued and redeemed. There is no way to participate passively in this market, as funds need to be highly active in order to keep up with the ever-changing composition of the universe. The only question is how this is done.
“Thirdly, the high yield bond market is too big to actively track – there are around 1,900 individual securities in the US market, but the major ETFs only hold around 1,000. This means these ‘trackers’ have taken an active decision to ignore hundreds of securities, leaving behind plenty of opportunities for active managers.”
Finally, Baines adds that, in general, benchmark-based approaches to credit investing have a major flaw. “Credit indices are weighted based on the amount of debt outstanding so companies with a higher level of indebtedness make up a larger proportion of the index,” he says. “Index funds are continuously forced to reallocate capital from improving credits (companies reducing debt) to deteriorating credits (companies increasing debt). To us, this is a highly illogical way of managing a credit fund.”