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In recent years, the passive equity space has been successful in driving a wave of investors towards low-cost passive funds that have managed to replicate their index. Their actively-managed counterparts have struggled with eroding market share.
The active-passive debate has now shifted to the fixed income space, in particular regarding high yield. Asset allocators have turned to passive management in high yield in order to gain exposure to the category. Indeed, the high yield asset class has seen significant inflows on a year-to-date basis as investors (including bond investors) are moving down the risk scale under the impetus of Central Bank easing. These flows have in good part been driven to ETFs.
Investors should however not think that the same rules apply in fixed income passive investing as in equities in terms of benchmark replication.
We compared a sample of 15 broadly marketed European high yield funds with the three largest European high yield ETFs over the past six years. It turns out that at least half of the actively managed funds outperformed their ETF counterparts.
Source: Bloomberg, DPAM calculations
Obviously, this would have required the investor to pick the seven funds at the start of the year that would do best. However, if one looks at cumulative performances over different periods since the end of 2013, at least 70% of the actively managed funds outperform the ETFs. In other words, if one picked a high yield fund at the start of 2014, one would have been better off with an actively managed fund in 81.3% of the cases.
% of funds outperforming ETF – since:
Source: Bloomberg, DPAM calculations
And the differences in return over that period would have been significant: from 2 percentage points to as much as 20 or more percentage points if one had been lucky enough to pick the top-performing fund at the end of 2013.
This can be explained in the first place by the fact that the underlying index of the ETFs is an index that takes into account only the most liquid part of the broad high yield market, such as the Bloomberg Barclays Liquidity Screened Euro HY Index (BEHLTREU) or the Markit iBoxx EUR Liquid High Yield Index. In other words, the ETF only tries to reproduce the most liquid part of the market. This part of the market is often the most expensive (and potentially crowded) part of the market as well.
Investors need to be well aware that buying a high yield ETF does not give the same exposure as an actively managed fund and that returns over the long run can differ significantly. The graph below shows the evolution of the Market iBoxx vs. the two ICE BofAML high yield indices which are used as a benchmark by a good part of the European high yield funds.
Source: Bloomberg, ICE BofAML, Markit iBoxx, DPAM Calculations
Furthermore, ETFs tend to underperform their index by on average 60bps per annum. This can be attributed to the fact that they also charge meaningful fees to their investors. An ETF will likely also manage inflows and outflows without delay, incurring bid-ask spreads that can become an important drag on performance.
An active manager on the other hand can tactically wait to invest if the market is expensive and can also benefit from new issue premiums in the primary market.
Another argument in favour of active management in high yield is that the good managers also outperform their benchmark. Over the past five years, the top third of fund managers have significantly outperformed their benchmark as shown below.
In our opinion, a critically important difference with ETFs is fundamental research: picking the right credit at the right price and understanding the underlying evolution of the business. Bottom-up research also enables good fund managers to avoid investing in the wrong credits and hence avoid the losses that this entails.
So in conclusion:
01 A high yield ETF does not necessarily give exposure to the whole high yield market: ETF investors might be missing out on an attractive and valuable part of the universe.
02 Furthermore, ETFs also underperform their index.
03 Good funds outperform ETFs consistently and by a significant margin.