Investors have been flooding into exchange-traded funds because they think they’re cheap.
But costs are tricky, and assessing them can be more complicated than simply looking at how much funds say they cost. This is especially true in less-traded debt, such as speculative-grade bonds, which tend to be more unpredictable and expensive to trade.
A perfect example of this is State Street’s $11.7 billion SPDR Bloomberg Barclays High Yield Bond ETF. It has returned 7.37% in the past three years, or 5.4 percentage points less than its benchmark index. That’s equal to an average annual lag of 1.69 percentage points in the period.
In other words, while this ETF, which trades under the ticker JNK, says its expense ratio is 0.4%, a more realistic assessment of the cost over the past three years amounts to 1.69%.
This tracking difference is “the most under-rated piece of ETF due diligence that’s out there,” said Bloomberg Intelligence’s Eric Balchunas. “Your net cost is how much did you miss that benchmark by.”
Jeffrey Gundlach, chief executive officer of DoubleLine Capital, spotlighted this fund’s performance on Twitter on Thursday, noting it has even gained less than a broad investment-grade bond benchmark in the past three years.
The State Street ETF stands out for having a notably high cost by this measure. Perhaps this is why so many investors have flooded into its rival, BlackRock’s $18.7 billion iShares iBoxx USD High Yield Corporate Bond ETF that trades as HYG. This fund has an expense ratio of 0.5%, which is higher than the one for the State Street ETF, but a tracking difference of just 0.79% on an annualized basis over the past three years.
In other words, the effective cost of the BlackRock junk-bond ETF is about half as much as the one on the State Street ETF over the past three years. Indeed, the BlackRock fund has really become the go-to ETF for high-yield debt traders. Its assets have ballooned by 50% since August 2014 compared with the 25% growth in the State Street fund’s assets.
There’s a long-standing debate about how expensive it is to trade in more-esoteric bonds. It could be that the State Street fund targets more difficult-to-trade bonds or was forced to turn over more of its portfolio because of changes in the underlying index.
Either way, it’s important for investors to account for the true costs when flocking to ETFs. Many think these funds are cheaper than other types of funds, but that’s not always the case, especially when dealing in less-liquid debt.