Why passive ETFs might be forfeiting some of high yield’s return potential

The limitations of passive high-yield ETFs are evidenced by persistent and consistent underperformance compared against a broad market index. One reason for this shortfall is that some of the largest passive high-yield ETFs attempt to track a narrower benchmark comprising the largest and most liquid high-yield bonds. This approach reduces the value that can be provided by using a broader, more diversified approach to smaller or less-familiar issuers and has the effect of limiting long-term return potential while being exposed to similar market beta. 

Shifting sector allocations can potentially add value

Another potential source of return that investors may forfeit with passive high-yield ETFs comes from not having the ability to adjust sector or industry weightings. By design, passive ETFs have index-like sector allocations. Unlike government or investment-grade bond funds, where default risk is typically quite low, or equity funds, where the returns of outperforming sectors are often much higher than those of negative-returning sectors, the high-yield bond market regularly has periods of time in which the returns of the most underperforming sector can have an outsize effect on total returns. In short, sector allocation is crucial.

An active approach can take fundamentals into consideration, tilting toward attractive areas of the market and away from those that face hurdles while managing through troubled situations that occur. For example, real estate investment trusts (REITs) currently make up about 3.6% of the ICE BofA US High Yield Constrained Index, with office, retail, and mortgage REITs each a meaningful portion of the sector.

In our view, some real estate sectors face continued headwinds not only due to still-elevated vacancies, rising maintenance costs, and elevated lending rates, but also to the structure of REITs, which requires the company to pay out materially all of its operating cash flow to equity holders, leaving little support for debt investors. Even in areas of stress such as office properties, restructuring expertise and familiarity with the asset class can materially improve outcomes for active investors. While default rates have been subdued in recent years, prices tend to adjust well before a final outcome, which can be to the detriment of those holding passive exposure.

Assessing risk and reward across credit quality

Passive ETFs are also at the whim of their benchmark with respect to credit quality, even when relationships between higher- and lower-quality borrowers present significant opportunity. For example, as interest rates have risen, investors have been able to receive historically high yields even in the higher-quality areas of the high-yield market. Late last year, absolute yields across most portions of the high-yield credit market were in their top decile in the last 20 years, and investors were able to earn significant returns with index-like exposure.

More recently, spreads have tightened, but yields remained reasonably high. Notably, the incremental risk for the lowest-rated high-yield credit (CCCs) compared with the highest-rated high-yield credit (BBs) has tightened significantly. 

In our view, this may warrant a risk posture that skews differently than the optimal risk/return profile provided by the market just a few months ago. Such nuance in positioning may enable investors in the current environment to receive relatively high income without being overexposed to lower-quality areas of the market, especially as spreads are now below their long-term average.

Active ETFs can quickly take advantage of opportunities

Constrained by their methodology, another limitation of passive ETFs is their inability to quickly adjust to changes within the high-yield market. This is a significant disadvantage as, in our view, exposure to the asset class and risk positioning within it could be thought of as a dimmer, not a light switch.

As investment-grade issuers grapple with higher-for-longer base rates, we expect that some will eventually be downgraded to high yield. Active managers can be nimble in this environment, allocating (and even overweighting) to these fallen angels, a segment of the market that’s historically provided attractive risk/return opportunities. Security selection in such situations can also be crucial; for example, some past and future potential fallen angels have just one of their many bond issues with so-called coupon steps, or bonds that pay a higher rate if they’re downgraded.

Finally, active managers may also be able to better capture value from new issuance and trading than their passive counterparts. In the primary market, syndication and allocation can be a complicated and iterative process. We expect significant new issue volume in 2024, making this point even more relevant. Per J.P. Morgan, new issuance through the first three months of 2024 is approximately 118% higher year to date compared against the same period in 2023. Advancements in technology have also allowed for active managers to reduce the cost of repositioning, often sourcing or reducing bond positions from forced buyers and sellers in passive funds.

How active high-yield ETFs can help

From an investor’s perspective, it’s easy to see the appeal of passive high-yield ETFs. The ETF structure provides exposure to many liquid asset classes in a highly liquid, transparent, and tax-efficient way, and away from high-yield fixed income, passive structures have generally been able to deliver benchmark returns with a low tracking error.

As the ETF industry evolves and more active high-yield ETFs become available, we believe investors may be provided with the opportunity to receive these same benefits while also potentially avoiding some of the challenges to long-term returns that have been resident within large passive high-yield ETFs. An active ETF structure combined with a consistent portfolio construction process built on fundamental inputs, diverse positioning, and credit expertise may provide investors with the best chance of capturing the full potential available within high-yield fixed income.