The passive equity space has been successful in driving a wave of investors to low-cost passive funds that have managed to replicate their index, as their actively managed counterparts have struggled with eroding market share.
But as the active versus passive debate takes hold of the fixed income space, with high-yield funds in particular, investors should not be fooled into thinking the same rules of comparison apply.
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.
To understand why, we need to consider that the broad high-yield market, with limited institutional size trading, can’t be replicated in the same way as the equity market. As a result, passive ETFs in the high-yield space seek to mimic benchmarks that represent only the most liquid portion of broad-market high-yield indexes, such as the ICE BofA ML U.S. High Yield Index (the “High Yield Index”).
These highly liquid benchmarks have underperformed the High Yield Index, and the ETFs have underperformed their highly liquid benchmarks. That’s in stark contrast to the equity space, where passive index funds have closely mirrored their benchmark performance, with low transaction costs and generally very low fees.
We believe a primary reason for the high-yield ETF underperformance is that the most liquid portion of the index is chronically overvalued. The most liquid high-yield bonds are issued by companies that are the largest borrowers in the high-yield market. While the largest companies in the S&P 500 Index are typically strong businesses, the same can’t be said for the largest borrowers in high yield.