When Junk Isn’t Junk: High Yield Bond ETF Coming Up Short.

ETFs are one of the most popular financial innovations of recent history. The ETF universe provides low-cost access to broad asset classes, sectors, and investment themes. Investors now have more options to express their view on the market in a liquid and cheap investment vehicle. Overall, the rise of ETFs has been an overwhelmingly positive development for investors. These ETFs charge a management fee on the net asset value (NAV) of the fund, a fee which can vary significantly depending on the fund selected. Many investors see the advertised expense ratio and believe this is the only cost associated with these funds. However, not all ETFs are created equally and many have costs hidden beneath the surface that affect performance and cause almost all ETFs to lag their benchmarks, and in some cases by a considerable margin.

Lisa Abramowicz of the Bloomberg Gadfly column points out one such example that is striking: the SPDR Bloomberg Barclays High Yield Index ETF (JNK). This ETF aims to track the performance of the Bloomberg Barclays US High Yield Bond Index. While that is an admirable goal, it is important to note that ETF returns are not guaranteed. The fund fact sheet[1] shows that JNK has lagged the performance of its benchmark index by 2.25% annualized since its inception in 2007, despite having an advertised gross expense ratio of 0.40%. This is a very wide margin of underperformance, so what factors have contributed to a passive investment vehicle lagging its benchmark to such a great degree?

One potential factor explaining the performance gap is the nature of bond index construction. When compared to equity indices, bond indices can be nearly impossible to replicate at a low-cost. Bond indices contain thousands of securities, many of which are illiquid and do not trade without significant transaction costs. This creates a challenge for a fund with an objective to track such a broad index. It is nearly impossible to match the exact securities at the same index weight. Therefore, funds try to build portfolios that are as close to the functional index as possible. For a fund to mimic a fixed income index like the Bloomberg Barclays US High Yield index, they must manage credit quality and performance, sector and issuer weightings, duration, coupon, and other measures with near perfection in order to achieve returns similar to that of the broad index. Maintaining correct weights in the High Yield index ETF is further complicated by new issuances and changes in credit ratings that drive new members in and out of the index, forcing the fund to constantly make adjustments in order to track changes in the benchmark index over time. These trading costs can be significant and point to the second potential factor behind JNK’s 2.25% annual performance gap.

The second and most glaring cost for such an ETF is the potential mismatch in liquidity of the ETF’s shares traded on an exchange and liquidity of the underlying assets in the ETF. One of the most valuable features of an ETF is the deep, instant liquidity provided by an exchange that clears trades in the ETF near the prevailing NAV of the ETF. Most investors in an ETF assume that when they buy or sell the fund, the price at which they are executing represents the approximate value of their share of the underlying assets in the ETF. This assumption can be nothing more than an illusion at times. For JNK, many high yield bonds trade infrequently and carry stale prices not reflective of the actual buying or selling price that is achievable at that instant for an investor. Therefore, at any point in time during a trading day the price being used to estimate the fair value of an ETF portfolio may poorly reflect the price at which the manager would actually be able to buy or sell the securities in the fund. In times of market stress and price volatility, this flaw becomes more glaring, as ETF managers are forced to buy and sell depending on the flows into or out of the funds throughout a day. If there is a mismatch in supply and demand for the ETF shares, the fund manager increases or decreases the number of shares outstanding to correct the imbalance, resulting in inflows or outflows of funds for the ETF. Therefore, when many independent investors sell their ETF shares simultaneously, the fund manager is forced to sell underlying assets to meet redemptions, often at disadvantageous prices. This leaves the real NAV of the fund at risk as ETF managers are forced to execute trades at levels below estimated NAV for the fund. Remaining ETF shareholders are left holding the remaining portfolio net of these transaction costs and the premiums paid because of that illiquidity. These transaction costs do not arise for the underlying benchmark index. And since the fund is always simply trying to match the composition of the underlying index, the fund will never be able to regain ground on the index even when corresponding inflows arrive. Transaction costs arise on both sides of a transaction, so rising demand for the ETF only further widens the performance gap.

The rise of ETFs is not a panacea for investors. The only guarantee that Index ETFs can offer is that they will underperform the underlying index which they are tracking over time. The only question is, by how much will they underperform? In many cases, the tracking error will be insignificant and reflective of the fund’s expense ratio. Do not assume, however, that the only expense within an ETF is its advertised expense ratio. The hidden variable transaction costs described above arise through the normal course of managing a broad portfolio of investments, particularly in illiquid asset classes like high yield bonds. These costs are real, and investors should tread cautiously when evaluating the thousands of ETFs now available. The actual costs incurred in an ETF can exceed advertised costs by a wide margin and this can lead to inadequate returns for the risks assumed.

[1] https://us.spdrs.com/public/ETF-JNK_20170630.pdf?ticker=JNK&type=FUND_DOC_FACT_SHEET

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