Appetite for beta drives growth in junk bond ETFs

couchI came across an interesting debate on the merits and drawbacks of high yield bond ETFs in today’s Financial Times. Joe Rennison and Robin Wigglesworth explain that although junk bond ETFs are hot with investors right now, their performance hasn’t exactly been stellar.

Call it a gap between perception and reality as investors continue to flow money their way.

Here’s the issue. Returns from junk bond ETFs are much lower than the underlying indices they trade. Moreover, they tend to perform worse than the average actively managed mutual fund. Specifically, write Rennison and Wigglesworth, the iShares’ HYG ETF has underperformed the iBoxx index it tracks by 0.16% this year and 0.58%, on average, since it launched in April 2007. At the same time, the average high-yield mutual fund has underperformed relative to the average high-yield mutual fund between January 2008 and September 2015, according to Lipper data.

That’s the data. But the reality is performance isn’t driving demand for bond ETFs—it’s liquidity and access. And that’s really important to keep in mind.

Fixed income ETFs have grown exponentially in the last few years—it’s the fastest growing asset class in the ETF space according, with total assets up 17% this year to a total of US$265 billion.

Part of the reason that ETFs tend to underperform lies in the way they replicate their indexes: junk bonds are notoriously hard to trade. In order to package them up on a liquid and accessible form, providers have to replicate performance through a subset of more liquid bonds. Hence, tracking error.

Then there are fees. Junk bond ETF fees are higher than those for equity-based products, not surprising given the greater complexity behind their construction.

But none of this appears to be an issue for investors facing massive challenges in the bond market. Bond ETFs, despite their challenges, are an important workaround for investors grappling with a rising rate environment where corporate bonds are getting harder and harder to come by.

ETFs then fit the bill when it comes to making short-term, tactical decisions in the bond market—and specifically in the high-yield space.

In an uncertain world, liquidity is everything.

Investors are also looking for more opportunities to add beta, after decades of hunting for alpha and alpha only. Beta is having its day in the sun and, for many institutions, ETFs are the way to get it quickly and cheaply. Moreover, investors often want both in the mix—particularly on the bond side, where active management is on the rise.

At the end of the day, investors need to sharpen up their understanding of ETFs and how they work, but doing that also involves a growing conversation about where they fit in a portfolio. Because right now, finding the right assets—particularly on the fixed income side—is getting harder to do. So fit and form might just trump performance and cost—at least for the time being.