Buoyed by rapid growth, junk bond exchange traded funds are one of the hottest tickets in town, however for some investors their actual performance has been less than compelling.

Fixed income ETFs are the fastest-growing asset class in the swelling industry and have increased assets under management by 17 per cent this year to $365bn.

However, some fund managers point out that the returns of junk bond ETFs are consistently much lower than the underlying indexes they track, and even perform worse than the average actively managed mutual fund.

 

“These ETFs have horrendous performance over time,” says Gershon Distenfeld, director of high yield at AllianceBernstein. “It’s awful. You’re better off pulling a fund randomly out of a hat than buying one of these ETFs. They just don’t track the market.”

For junk debt, much of that is concentrated in two vehicles — BlackRock iShares HYG with $15.4bn under management and State Street’s JNK, which has $11.9bn under management. They are popular for their ability to provide quick and easy exposure to markets that are often tricky to trade.

HYG, launched in April 2007, has underperformed the iBoxx index it tracks by 0.16 per cent this year and by 0.58 per cent on average annually since inception, according to data from Bloomberg. JNK, launched in December 2007, has underperformed the Barclays high-yield total return index by 2.59 per cent annualised since inception, despite slightly outperforming HYG.

Despite their growing popularity with institutional investors, both ETFs also returned less than the average high-yield mutual fund between January 2008 and September 2015, according to data from Lipper.

There are good reasons for this. The ETFs do not precisely replicate their indices, given the difficulty of assembling a liquid, easily-tradable portfolio of a junk bond universe where many securities often trade infrequently. Instead the ETFs consist of a subset of more liquid bonds and this results in a divergence in performance, or what is commonly known as a tracking error.

Moreover, the fees for junk ETFs tend to be much higher than for those based on equities. HYG charges 50 basis points and JNK costs 40bp, compared with only a few basis points for widely traded stock market ETFs.

Matthew Tucker, head of Americas iShares fixed income strategy at BlackRock, says this explains why HYG consistently trails its underlying index by between 0-0.5 per cent. Meanwhile, JNK’s even poorer performance — it consistently trails its underlying index by more than 1 per cent — is due to transaction costs, says David Mazza, head of research for ETFs at State Street Global Advisors.

When bonds enter or leave the underlying index, the ETF must follow suit, buying and selling debt to ensure it continues to track the index. iBoxx absorbs some of these transaction costs into its return calculations, but Barclays indices do not. That is why JNK fares more poorly than HYG when it comes to tracking its underlying bond market gauge.

Despite their expense and underwhelming performance, many investors still see a major role for ETFs, especially in providing a way to place short-term, tactical bets on the high- yield bond market.

ETFs trade more like stocks on an exchange and tend to be easier to buy and sell than the underlying bonds. The promise of liquidity has come under scrutiny, especially with regard to how ETFs perform in stressed markets, but many investors still point to the products as useful vehicles for quickly expressing a view.

“People are enamoured by market timing and liquidity,” says Krishna Memani, chief investment officer and head of fixed income at OppenheimerFunds. “Expecting ETFs to give you exact market returns is too much, but you get liquid exposure to the market.”

A number of larger institutional investors, such as mutual funds, have also piled into ETFs, using the product as a means to get exposure to the market, or “beta”, while a trader sources the specific bonds the fund wants to buy.’

“One of the biggest growth areas has been institutional investors, such as asset managers, using ETFs for interim beta exposure,” says Mr Mazza, adding that ETFs and actively managed funds are not mutually exclusive. “I am a big believer in combining active and passive management in fixed income,” he says.

Other investors point to the declining liquidity conditions in corporate bond markets making it harder to find high-yield debt to buy. Smaller asset managers may in particular struggle to gain access to certain bonds and sometimes choose ETFs as an alternative.

“With the lessening liquidity at big bank trading desks there is going to be more and more pressure for asset managers, especially smaller ones, to use co-mingled vehicles and not use individual securities because getting access to those securities is harder,” says Robert Cusack, portfolio manager at Whalerock Point Partners.

But for those investors that are able to choose, the message from Mr Distenfeld is clear.

“If you are trying to do high-yield as a trade for two months, then use the ETF,” he says. “But if you are making a strategic long-term investment you want an active fund because they do much better over time.”