There’s value and opportunity in European high-yield bonds today. But if you’re considering using an exchange-traded fund (ETF) to tap into the market, you may want to think again.

The reason is simple: Europe’s largest high-yield ETF has consistently underperformed the top 25% of actively managed European high-yield mutual funds. That’s true whether one measures performance over the past one, three or five years.

ETFs
By Katrina.Tuliao (https://www.tradergroup.org) [CC BY 2.0], via Wikimedia Commons
ETFs

This may be news to many investors. According to Thomson Reuters Lipper, bond ETFs were the best-selling assets within the European ETF industry last year. ETFs that invest in European corporate bonds were among the top sellers, pulling in 5.5 billion euros in 2016.

Why the rush into ETFs? Financial advisors often tell us that their clients like ETFs because they offer a low-cost and easy way to access the high-yield market and its high income potential.

That all sounds good. But when we dig a little deeper, we find that high-yield ETFs aren’t as cheap or efficient as they first appear—and that’s a big reason why their returns have lagged those of actively managed funds.

How Costs Can Add Up

Let’s start with costs. Most ETFs passively track an index. In theory, that should keep costs down. In practice, it doesn’t always work that way. This is especially so in a market like high yield, where it’s a lot harder—and more costly—to replicate an index than it is in the stock market.

The manager of an MSCI Europe equity ETF, for example, can easily buy all the stocks that make up the index, since the turnover of stocks within the index is low. That keeps trading costs and fees to a minimum.

In high yield, tracking a benchmark is more difficult. New bonds get issued and old ones mature. Some get called or tendered. The result: bonds go into and out of benchmarks often. To keep up, ETF managers have to trade more frequently, often at significant cost.

The Pitfalls of Passive Exposure

There’s another problem with indexing in high yield—it’s an inefficient and risky way to access the market. There are good reasons to consider European corporate bonds today, including attractive valuations, thrifty corporate borrowing habits and a highly supportive policy backdrop. But that doesn’t mean investors will necessarily want exposure to the entire market.

When it comes to high yield, issuer credit quality varies widely, and so do the risks. Active managers can draw on detailed credit analysis to discriminate among credits and sectors. They’re also likely to make better decisions about how to redeploy income from bonds that mature or are tendered.

Passive ETF investors, on the other hand, lend indiscriminately to every company that borrows enough to make it into the index. That can result in unwanted exposures to overvalued or risky sectors.

Paying a High Price for Liquidity

There’s another reason many investors gravitate toward ETFs: they’re liquid. Unlike mutual funds, which are priced just once a day, ETFs can be bought and sold at any time, just like stocks. This is a great thing if you’re a high-frequency trader who wants to short the high-yield market for a few days or a professional portfolio manager who needs to hedge her exposure for a short period.

But a large share of the people who have been buying high-yield ETFs aren’t traders. They’re investors who are saving for retirement or college or a home. To meet these goals, they need long-term exposure to the market and a hands-on strategy that can seize opportunities as they arise. They don’t really need intraday liquidity—and if they knew what it was costing them in terms of performance, they probably wouldn’t want it.

There’s another thing to consider: In a sharp market downturn, there’s no guarantee that high-yield ETFs will be able to deliver that liquidity as promised. This is because their growing popularity forces them to hold ever-larger shares of less liquid assets. If prices were to fall sharply, finding buyers might be a challenge, and investors who have to sell could take big losses.

ETFs have their uses, particularly for short-term traders and tactical exposure to the high-yield market. But they’re a poor choice for long-term exposure. Investors on the hunt for income and value are right to focus on European high-yield bonds. They just shouldn’t be doing it with ETFs.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.

Article by Jorgen Kjaersgaard, Gershon Distenfeld, Sahil Khan – Alliance Bernstein