The rise in passive investing has been undeniable over the past few years, particularly as people getting index-based ETF exposure have gotten outsized returns compared to higher-fee active funds that generally struggle to beat their benchmarks. But there’s a different story on the fixed-income side, and that includes the high-yield segment.
“In high yield, over most rolling five-year periods, more than half of active managers have outperformed investable passive alternatives and have done even better on a risk-adjusted basis,” said John McClain, CFA and portfolio manager at US-based Diamond Hill Capital Management, in a column for ThinkAdvisor.
The difference, McClain explained, lies in the fact that the broad high-yield market cannot be replicated in the same way as the equity market. While the high-yield market is broadly characterized by limited institutional-size trading, passive ETFs in the space seek to mimic benchmarks that represent only the most liquid portions of broad-market high-yield indexes.
“These highly liquid benchmarks have underperformed the High Yield Index, and the ETFs have underperformed their highly liquid benchmarks,” he said.
A primary reason behind that transitivity of underperformance is the chronic overvaluations in the most liquid portion of the index. While the largest companies in a given equity index are typically strong businesses, the fixed-income space is different: the most liquid high-yield bonds come from the largest-borrowing companies, which aren’t necessarily strong.
To underscore the point, McClain pointed to Community Health Systems Inc, which has one of the largest weightings in the High Yield Index but is faced with over US$13 billion in debt with a market capitalization of US$500 million. Historically, it has burned cash as a weak competitor with limited access to capital.
“Large ETFs and large actively managed high-yield funds seemingly pay up for the perceived liquidity offered by the largest borrowers,” he said. “The investable passive alternatives have also not kept up with their highly liquid benchmarks because of expenses and transaction costs.”
Another complication comes from the unique characteristics of distressed high-yield bonds. Fluctuating in size, that segment of the market has ranged between 1% and 30% of the high-yield market, he said. Aside from having credit-specific fundamental issues, such bonds can be difficult to source when ownership transitions from traditional asset managers to hedge fund managers.
“Active managers can outperform by concentrating more in the less liquid and often more attractively valued portion of the high-yield market,” McClain said. “Managers should not fall victim to evaluating an issue based on whether it’s in an index or its weight in that index. What’s important is analyzing the business, understanding the risks involved in the company and the bond, and determining whether there is more than adequate compensation for risk.”
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