Four reasons why bond ETFs underperform the index

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Four reasons why bond ETFs underperform the index
Photo by Miguel Á. Padriñán via Pexels

There are four main reasons why bond fund trackers have been significantly underperforming the index they are designed to track, a credit specialist has claimed.

Stephen Baines, fund manager for Artemis Investment Management, said: "Exchange-traded funds have delivered disappointing returns in the credit space, underperforming the markets they are meant to track."

This has been despite significant inflows of money in recent years into passive funds such as ETFs that track bond indices, as investors have sought ways to get exposure to credit without paying active fees or as a way to play the market through higher-frequency trading. 

It is impossible to run a buy-and-hold strategy in credit.Baines

But according to Baines, these strategies can work against the investor, causing them to end up with a fund that has a high concentration of risk, not to mention trading costs, and a significant deviation from the performance of the underlying bond index.

In a recent presentation, the manager highlighted the relative performances of the ICE BofA US High Yield Index against a typical ETF, in this case, the iShares iBoxx High Yield Corporate Bond ETF.

As the image below shows, the performance of the index has been much better than the fund designed to track it. 

 

Baines said there were four main reasons for this underperformance: fees, sampling error, trading costs and liquidity preference.

1) Fees

Baines said: "The index doesn’t include fees, so these become an immediate headwind. "Equity ETFs are very cheap. For example, the SPDR S&P 500 ETF Trust is just 9.5bps, but credit ETFs are not."

Using the iShares iBoxx High Yield Corporate Bond ETF as an example again, this is 48bps.

When you consider that some actively managed bond funds can be around the 50bps mark, there appears to be little difference in price between paying for active or passive.

2) Sampling error

When it comes to sampling error, Baines explained that investors in bond fund indices can end up on the wrong side of credit risk.

Basic equity index construction works on market capitalisation. With a bond index, the index is constructed based on how much credit a company has issued. 

But even when an ETF 'tracks' the index, it will not hold all the companies that are in that bond index. This automatically skews the ETF towards the most indebted issuers, which could pose enormous risks.

Baines explained: "There are more than 2,000 bonds in the US high yield bond market, but the leading ETF holds 1,321.

"While this is still a lot, many of the excluded bonds are smaller (less indebted) issuers and so the fund is concentrated in larger (more indebted) issuers."

3) Trading costs

Another key point is that the index return excludes trading costs. Baines said: "Unlike in equities, where index turnover is slow and small, it is impossible to run a buy-and-hold strategy in credit.

"Investors are forced to trade to reinvest proceeds from redemptions, to buy or sell issues that enter or leave the index through rating changes, and the ETF is a forced buyer of new issues after they have occurred."

4) Liquidity preference

According to Baines, ETFs are often used a tool by fast money investors or high frequency traders to add or reduce exposure to the high yield bond market.

But this often makes the ETFs the biggest buyers on up days and the biggest sellers on down days.

Therefore, the ETF tends to be buying on the offer side when bonds are expensive and selling at the bid side when bonds are cheap. This adds further to trading costs.

Baines added: "We can see this dynamic from looking at the discount and premium to net asset value. The ETF often fluctuates between -0.5 per cent and +0.5 per cent. This demand that the ETF has for liquidity comes at a cost from the rest of the market – in the form of lower returns."

Cost concerns or market quality?

Over the past decade, there has been a pronounced shift towards promoting passives, with exam curriculums seeming to favour a shift towards advisers using passives for most clients in a bid to drive down costs.

Even the FCA has repeatedly made the point that "Active fund management is necessarily more costly than passive fund management, and these costs can cause active funds to (on average) underperform the market."

But in a 2019 research paper on whether passive investing affects market efficiency and market effectiveness, the FCA said while choosing passive management might be "individually sensible", it could have an impact on the quality of the overall market.

The 16-page research note stated: "Each investor individually has an incentive to take market quality as given and opt for lower cost passively managed funds.

"If a sufficient proportion of investors do opt for passive management, then it is possible that these individually sensible choices may in aggregate lead to investor detriment due to their adverse impact on market quality and so on overall economic performance."

simoney.kyriakou@ft.com