Passive management strategies in high yield promote lax lending standards and sketchy supply, much as they did during the precrisis CDO boom. For investors, this could mean lower credit quality and a higher probability of default.

There’s a place for both passive and active strategies in a well-diversified portfolio. But many investors are using the former as a substitute for the latter. We think that’s a mistake—especially in high yield.

Investors find high yield appealing because it’s one of the few remaining fixed-income sectors that still offers attractive yields in today’s low-interest-rate environment. But a growing number are choosing to access the market with exchange-traded funds (ETFs), which passively track an index.

That can be chancy. The high-yield market is a complex one. Issuer credit quality varies widely, and so do the risks. Active managers can draw on detailed credit analysis to navigate the market and decide which companies to lend to. Passive ETF investors lend indiscriminately to every company that borrows enough to make it into the index.

This can create poor incentives and bad supply. If companies know they can borrow cheaply from passive lenders, some may conclude there’s no reason to run a tight financial ship by keeping leverage ratios under control. That could result in higher default rates and undermine the quality of the broader market.

Learning Lessons from CDOs

We don’t have to go too far back in time to see how this sort of thing can turn out. Today, we all know that mortgage lenders prolonged the US housing boom in the 2000s by making ill-advised loans to underqualified borrowers for houses they couldn’t afford. Lenders were able to make all those loans for one simple reason: they knew they could offload the risk onto someone else.

That someone else turned out to be all the investors who wanted exposure to mortgages. They got that exposure by piling into financial vehicles called collateralized debt obligations, or CDOs, which bundled different kinds of mortgage debt into individual securities that were then sold to investors.

All that investor demand allowed lenders to make riskier and riskier loans. Eventually, the music stopped—and investors who had blindly bought these CDOs were left holding a pile of bad loans.

Bad Borrowing Can Bite Back

A big rise in high-yield default rates probably wouldn’t set off a global financial crisis. But it could do plenty of damage to individual ETF investors who have let the bond issuers call the shots.

Investors got a sneak preview of this late last year when bonds from energy companies fell sharply along with the price of oil. For years, energy companies had been on a borrowing binge to finance investment in shale gas in the US and Canada. By 2014, they accounted for a bigger share of the Barclays US High Yield Very Liquid Index than any other sector (Display).

But when oil prices plunged, many firms’ exploration and production operations were no longer profitable, and their plight was made worse by the added cost of servicing their debt. Active managers could have stopped adding to their positions as the energy sector’s share of the index grew. That option wasn’t available to ETF investors.

High Risk, Poor Performance

Here’s another reason why we think ETFs are a bad choice when it comes to high yield: investors aren’t being compensated for all this added risk. Between January 1, 2008, and October 31, 2015, the two biggest ETFs—HYG and JNK—delivered annualized returns of 5.74% and 5.43%.

The top 20% of active high-yield managers, as rated by Lipper, returned 7.24%, after fees, during that period. Even the average active manager returned 6.3%. And both came with lower volatility, as measured by risk-adjusted returns.

In other words, investors interested in long-term exposure to high yield would have been better off if they had simply picked an active manager out of a hat.

High-yield ETFs have their place. They’re ideal for taking short-term positions and can be useful for hedging purposes.

But at this late stage in the credit cycle, it’s more important than ever to actively discriminate among high-yield issuers. A passive-only approach is akin to writing a blank check—just as investors did when they blindly bought CDOs. Everyone knows how that ended.

This article previously appeared in Barron’s.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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