ETFs to Invest in High Yield Bonds

Can a passive approach to high-yield bonds can deliver excess returns compared to their actively-managed fund peers over the long run?

Niels Faassen 30 January, 2018 | 11:55AM
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Niels Faassen: The active/passive 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.

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 run?

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 (SHYG) and the iShares $ High Yield Corporate Bond ETF (SHYU). In terms of performance, both consistently land in the third return quintile of their respective category. On a risk-adjusted basis, as measured by Sharpe ratios, they fall short of consistently beating their category averages.

Both ETFs come with an ongoing charge of 50 basis points. Although not the cheapest passive options, they’re nonetheless priced competitively against the average active high yield fund.

So even despite a clear cost advantage for high-yield ETFs, these generally fail to outperform category averages.

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 the index level by focusing on the most liquid parts. On the one hand this has facilitated replication and improved tracking ability. However, on the other hand the focus on liquidity has come with an obvious downside, namely that of not providing a comprehensive representation of the market.

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.

High-yield bond ETFs do what they’re supposed to do – that is, track their benchmark at low-costs. Ultimately, however, this is an area where the value of information and the flexibility of a non-benchmark-tied mandate seem to provide a clear edge, which is why the largest high-yield passive funds in the EUR and USD high-yield Morningstar Categories are awarded Morningstar Analyst Ratings of Neutral.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
iShares $ High Yld Corp Bd ETF USD Dist GBP74.56 GBP0.20Rating
iShares € High Yield CorpBd ETF EUR Dist GBP85.00 GBP0.43Rating

About Author

Niels Faassen  is a fund analyst for Morningstar