Why European High-Yield ETFs Don’t Deliver

There’s value and opportunity in European high-yield bonds today. But if you’re considering using an exchange-traded fund (ETF) to tap into the market, you may want to think again.

The reason is simple: Europe’s largest high-yield ETF has consistently underperformed the top 25% of actively managed European high-yield mutual funds. That’s true whether one measures performance over the past one, three or five years.

This may be news to many investors. According to Thomson Reuters Lipper, bond ETFs were the best-selling assets within the European ETF industry last year. ETFs that invest in European corporate bonds were among the top sellers, pulling in 5.5 billion euros in 2016.

Why the rush into ETFs? Financial advisors often tell us that their clients like ETFs because they offer a low-cost and easy way to access the high-yield market and its high income potential.

That all sounds good. But when we dig a little deeper, we find that high-yield ETFs aren’t as cheap or efficient as they first appear—and that’s a big reason why their returns have lagged those of actively managed funds.

HOW COSTS CAN ADD UP

Let’s start with costs. Most ETFs passively track an index. In theory, that should keep costs down. In practice, it doesn’t always work that way. This is especially so in a market like high yield, where it’s a lot harder—and more costly—to replicate an index than it is in the stock market.

The manager of an MSCI Europe equity ETF, for example, can easily buy all the stocks that make up the index, since the turnover of stocks within the index is low. That keeps trading costs and fees to a minimum.

In high yield, tracking a benchmark is more difficult. New bonds get issued and old ones mature. Some get called or tendered. The result: bonds go into and out of benchmarks often. To keep up, ETF managers have to trade more frequently, often at significant cost.

THE PITFALLS OF PASSIVE EXPOSURE

There’s another problem with indexing in high yield—it’s an inefficient and risky way to access the market. There are good reasons to consider European corporate bonds today, including attractive valuations, thrifty corporate borrowing habits and a highly supportive policy backdrop. But that doesn’t mean investors will necessarily want exposure to the entire market.

When it comes to high yield, issuer credit quality varies widely, and so do the risks. Active managers can draw on detailed credit analysis to discriminate among credits and sectors. They’re also likely to make better decisions about how to redeploy income from bonds that mature or are tendered.