March 17, 2009
Exchange Traded Funds (ETFs)
ETFs avoid many of the problems with actively managed funds, because they have lower expense ratios, lower cash levels, lower turnover, and they track a highly structured index.
But ETFs have other problems, which are illuminated in the three ETFs tracking the high yield sector:
Fund |
Index Tracked |
Expense |
Yield |
Number |
HYG |
iBoxx $ Liquid High-Yield |
.50 |
17.28 |
50 |
JNK |
Barclays High Yield Very Liquid |
.40 |
18.87 |
120 |
PHB |
Wachovia High-Yield Bond |
.50 |
N/A |
53 |
With over $2 billion in assets, HYG is the default proxy for the sector, and it holds approximately 50 highly liquid bonds. But holding only 50 bonds causes a lack of diversification.
JNK is fairly similar to HYG with about twice as many holdings. It has just over $900 million in assets. PHB is fairly new and uses a quantitative overlay to choose the issues with the best credit quality. It has $62 million in assets.
A highly liquid high yield bond is an oxymoron. On a good day, these bonds might trade once, and most of the time they don’t trade at all. For ETFs, which must be priced every 15 minutes, that creates lots of problems.
One is that ETFs typically trade at significant discounts or premiums to the NAV of the index they track. HYG, for example, currently trades at a 3% premium.
A related problem is tracking errors relative to the index. This was demonstrated in 2008 by the AGG ETF, which tracks the broader bond market. The AGG returned 7.91% versus 5.24% for the underlying index. The 172 bonds that make up the ETF were supposed are supposed to track the index, which contains more than 9,000 bonds, but high volatility and illiquidity in 2008 kept that from happening.
Liquidity problems don’t exist in the equity markets, where ETFs work very well. But in the bond market liquidity matters a lot more for ETFs than it does for mutual funds and, according to Matt Hougan of Index Universe, these problems are at the most extreme in the high yield market. “Finding the sweet spot between liquidity and diversification is the huge issue in bond market ETFs,” Hougan said.
There are no true high yield index funds. Vanguard’s offering, its High Yield Fund (VWEHX), is an actively managed fund with a low expense ratio (.25 on investor shares). It invests in better-quality high yield bonds, and its yield to maturity is currently 12.7%.
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