Capitalize on Bond Market Inefficiency with These ETFs

by JT on September 30, 2012

The rise of the exchange-traded fund has forever changed the financial markets. With the click of a button, investors can now buy and sell hundreds of holdings with a single instrument. Long-term investors can buy established index portfolios for only a few basis points per year in expenses. And ETFs have significantly improved liquidity in the capital markets by buying, selling, and lending their shares to short sellers. One corner of the investment universe may be getting ahead of itself. Bond market ETFs are distorting the market, making it possible for smart managers to beat the index by buying what traditional bond indexes cannot.

Bond ETFs: A Complicated Layer on the Market

Equities are highly liquid. Bonds, however, are not. Where one might buy and sell a large cap stock in a matter of seconds, buying or selling a debt security from the same company might take hours or even days…unless you submit an above-market bid. The explosion in exchange-traded products has overwhelmed the natural growth in the fixed-income market. This year, bond ETFs will make up 10% of all bond volume, according to Blackrock – 150% more than last year. Index ETFs are ruled by increasingly complicated prospectuses, which seemingly interject arbitrary trading decisions into what should be a simple operation: tracking the bond market. An article in Barron’s notes that in the high-yield segment, massive index ETFs like the SPDR Barclays Capital High Yield Bond ETF (JNK) have rules-based trading models that may leave untapped values. The fund is barred from buying bonds that were issued in tranches smaller than $600 million. My own look at the popular junk bond ETF iBoxx $ High Yield Corporate Bond Fund (HYG) reveals that it can hold only issues from companies with outstanding bonds with face value of more than $1 billion, and which have face value of at least $400 million as a tranche. In short, indexes are limited only to the largest issues in the junk bond universe. That makes for opportunity among the industry’s only active manager. The AdvisorShares Peritus High Yield ETF (HYLD) beat the indexes in the junk market, mostly because it was able to purchase what the indexes were not. Most importantly, the bond fund is actively managed and can buy or sell positions on its own accord, making it possible to hold cash when indexes would be ordered to immediately buy bonds in the index at any price, often paying far more than what an active manager would for the same debt security. AdvisorShare’s ETF returned 11.26% to investors year-to-date versus 9.64% for SPDR’s JNK, and 8.06% for iShares’ HYG ETF.

Going Long on Bond Funds

There are more than 200 bond ETFs, but only 17 are actively-managed. While investor interest in actively-managed ETFs is muted by index favoritism, the best returns in bond funds might just be in active funds, not passive funds. By design, passive indexes make buying and selling decisions based on inflows and outflows. As these large funds become even larger, their impact on the bond market will be seen in the number of bonds selling at a premium or discount as bond index funds buy and sell with market orders. You can see a similar effect in small cap stock performance following inflows and outflows of the Russell 2000 index and its ETFs. Investors know that there is a limit to outperformance which is governed primarily by the amount of assets under management. Most market inefficiencies are quite small. So far, the AdvisorShares Peritus High Yield ETF (HYLD), with less than $130 million under management, has been able to navigate through the market to find underpriced issues – and it has undoubtedly sold holdings at a premium to large index ETFs required to invest new fund flows. Junk bond ETFs are devouring investor capital after Bernanke signaled that quantitative easing would continue indefinitely. With only 4 AAA rated companies remaining in the S&P500 index, junk bonds were the recipient of 40% of all bond inflows that same week.  Investors chasing high yield, international exposure and lower correlation are also chasing international bond ETFs. It is in periods of aggressive buying and selling of bond indexes that small operations will generate the most alpha. Keep in mind that AdvisorShares’ ETF has only $1 in assets for every $225 in assets at the two biggest junk indexes.

Up and Coming Funds

Investors who want outperformance are likely to find it for quite some time in hiring active managers in the junk bond space. The AdvisorShares Peritus High Yield ETF (HYLD) is an attractive ETF for junk bond investors. Later this year, FirstTrust will launch its own actively-managed junk bond ETF, joining AdvisorShares as the only firm competing for actively-managed junk bond investment capital. FirstTrust filed with the SEC in July. I am especially intrigued by First Trust’s new issue. In filing with the SEC, it revealed that it may invest as much as 15% of assets in illiquid debt securities – going even further than AdvisorShares’ fund in the search for alpha. So long as these funds stay small, investors should expect outsized returns. Bottomline: As the junk bond ETF space becomes crowded, active funds are likely to produce significant alpha, outperforming oversized index ETFs that dominate and overwhelm the thinly-traded market for speculative bond issues.  I like to use budgeting software to ensure my investments are keeping up with expectations as well.

Disclosure: No position in any tickers mentioned here.

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