Why ETFs Aren’t a Good Fit in European High Yield

The index-tracking trend is firmly entrenched. But do investors recognize the big differences between stock and bond ETFs? And do they appreciate that these can cause European high-yield ETFs to lag?

More investors are choosing to take their exposure to fixed income via passive approaches, especially exchange-traded funds (ETFs). Many seem to assume that what they’ve learned about equity ETFs will also apply to their bond counterparts—unaware that there are vital differences between the two, particularly in high yield. And costly differences can have a big impact on how effectively high-yield ETFs deliver.

Europe’s actively managed high-yield funds measure their performance against a range of indices, most often various Bank of America Merrill Lynch and Bloomberg Barclays high-yield benchmarks. They set a high performance bar—significantly higher than the iBoxx Liquid High Yield Index which most European high-yield ETFs aim to track (Display).

The iBoxx holds many more short-dated, low yielding bonds—which explains why its beta seems significantly worse. Europe’s biggest high-yield ETF has consistently lagged both the active manager indices and the iBoxx itself. Most importantly, the ETF has returned significantly less than Europe’s actively managed high-yield funds over one, three and five years, as shown in the Displaybelow.

What are the reasons for this performance gap? We think the answers lie in failure to recognize that ETF structures and the inherent nature of the high-yield asset class just aren’t a good fit.