April 2017 saw the 10-year anniversary of the largest US high yield bond ETF, which delivered total returns of 70.8% or 5.5% 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% cumulative (7.4% per annum) over the same timeframe.
Below, he outlines three reasons why tracker funds in this asset class underperform to this extent.
“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.
“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, he 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.”
Stephen Baines, co-manager of the Kames Short Dated High Yield Global Bond Fund