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Active management

Let’s banish benchmarks and compare active funds to ETFs

By David Ennett, Head of High Yield, Fixed Income

In the last 12 months there have been inflows of $2.6bn into the iShares $ High Yield ETF. Investors clearly think that passives work well in fixed income and they are undoubtedly a growing trend. But should they be?

The truth about trackers

Fixed income ETFs may be rising in popularity, but we believe their true nature is not completely clear to investors. Trackers may claim to let you inexpensively buy ‘the market’, but in truth, they can’t.

Bond indices have thousands of constituents and so full replication of the market isn’t practical. Even by attempting to copy the index, passives incur high trading costs which eat away at returns, much more so than the low management fees suggest. And without experienced managers at the helm, in times of stress an ETF can trade at material deviations from its net asset value given the liquidity landscape of high yield.

1. Passives don’t even try to track “the market”

What investors might not realise is that for these reasons, passives don’t even try to track the market. The iShares $ High Yield ETF, for example, sets its benchmark as the iBoxx $ Liquid High Yield index – a subset of the broader high yield universe.

This subset has about half the number of bonds – circa 1,000 versus 2,000 – versus the dollar high yield market (as measured by Merrill Lynch) while its ratings, sector and country skews are different. For example, the iBoxx Liquid index has double the exposure to the service sector versus the Merrill Lynch index, but just a third of the basic industry sector weight.

These differences are evident from the performance of the index versus the ‘real’ market, as shown in Chart 1 below. The blue line represents the iBoxx $ Liquid High Yield index, which clearly trails the market, shown by the grey Bank of America Merrill Lynch index line.

And not only does the ETF not track what investors think it’s tracking, it fails to keep up with its own benchmark. This is clearly shown by the lagging orange line, representing the high yield ETF, and revealing the truth behind trackers.  
 
Snowden chart1

2. Passives don’t deliver what active managers can

It is clear that there are limitations of passive fixed income – and that’s before mentioning that they are designed to buy the most indebted issuers, offer no duration management rather unwanted duration extension, have significant concentration risk, with little liquidity management, and no ability to take advantage of the inefficiencies and opportunities the bond market offers.

So while not all actively managed funds are worth the management fee, some definitely are.

Actively managed funds benefit from the expertise of market specialists with the knowledge of how to trade in a relatively illiquid market.

3. Putting our own active fund to the test

Using the Kames High Yield Global Bond Fund USD share class versus the USD-hedged versions of the market index, ETF and ETF benchmark, we plotted returns for the longest time period on offer in Chart 2. While we don’t always beat the market (which investors cannot buy), we clearly beat the ETF, which continues to trail its own benchmark. 

hygb 10 year article chart 2

To put these returns into context, the ETF has over 10% in CCC-rated debt, versus less than 1% in the Kames fund, so we are also delivering better returns with less risk. 

Note that all performance is shown net of fees. So if ETFs are considered cheap, we must ask – at what cost? 

So when assessing if a fund has beaten the market you need to consider what you mean by the very term, ‘market’. Do you mean an index – aka a spreadsheet – that enjoys immediate, infinite, and costless liquidity, or the closest thing to it, ETFs which have to operate, like us, in the real world? Active management may appear to struggle in a theoretical world, but for the real one most of us inhabit, it remains the best way to access the asset class.

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