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ETFs: Passing Marks For Liquidity, But What About Performance?

By Alliance Bernstein Proponents of credit exchange traded funds (ETFs) claim the last week of market turmoil was a test for these instruments-and that they passed. We think this takes grading on a curve to a new level. The cheerleaders say ETFs succeeded because they traded regularly after a high-yield mutual fund failed and barred investor withdrawals. Here’s what they’re not telling you: in exchange for this liquidity, investors ended up with instruments that have woefully underperformed active mutual funds-recently and over many years. For long-term investors who are saving to pay for college or retirement, that’s an awfully steep price to pay for something they don’t really need. The numbers speak for themselves: Over the first 11 months of this year, the two largest ETFs – HYG and JNK – have sharply underperformed the average active manager, not to mention their own benchmarks. They’ve also trailed the average active manager so far in the fourth quarter ( Display ) and since the start of December, one of the year’s most volatile months so far. ETFs’ longer-term performance falls short, too. In fact, not only have active managers outpaced ETFs over the long run, they’ve done it with lower volatility, as measured by risk-adjusted returns. The Sharpe ratio, which measures return per unit of risk, was 0.45 for JNK and 0.51 for HYG between February 2008, shortly after they began trading, and November of this year. For the top 20% of active high-yield managers, it was 0.71. How Much Liquidity Is Enough? Is the ability to get in or out of an ETF at any point in the day worth the underperformance? For asset managers and traders who need to trade frequently to hedge positions, maybe. After all, they’re not investing in these instruments as long-term income generators. But a large share of the people who own high-yield ETFs aren’t traders. They’re regular folks saving for college, or to buy a new home, or for retirement. In other words, they’re investors, not traders. Most probably aren’t doing any intraday trading at all. If they’re buying ETFs for the liquidity, they’re paying-dearly-for something they don’t need. In our view, an actively managed mutual fund is likely to offer higher potential returns over the long run – and give investors a better chance of meeting their goals. In fact, the data suggest that investors who want long-term exposure to high yield would do better to pick an active manager out of a hat than invest in an ETF. With Mutual Funds, Diversification Is Key All well and good, some investors are no doubt thinking. But what happens when mutual funds fail? That’s a fair question. Liquidity is important for everyone, as the failure of Third Avenue Management’s Focused Credit Fund illustrates. But it’s important to remember that this mutual fund was not a typical high-yield fund. It focused almost exclusively on risky distressed debt issued by highly leveraged companies. These types of assets are relatively illiquid, and that became a problem when large number of investors wanted to sell their shares. In other words, investors were promised “daily liquidity”-the ability to buy or sell shares in the mutual fund at the end of each trading day-but the assets the mutual fund owned could not be bought or sold on a daily basis. These types of strategies are bound to fail eventually. Most high-yield managers follow more diversified strategies that focus on a wide array of higher-quality assets. Of course, investors should still make sure their investment managers have a dynamic, multi-sector approach and are managing their liquidity risk effectively . Those who do a good job will be in position to meet redemptions during downturns and seize opportunities as they arise . That’s something Third Avenue couldn’t do. High-yield ETFs can’t do it, either . The recent turbulence in the high-yield market probably isn’t over. But we don’t think that should concern long-term investors too much. In our view, the best approach at this point is probably to ride out the storm. The intraday liquidity ETFs offer comes at a high price-and if you’re a long-term investor in high yield, you shouldn’t be paying it. 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. Disclosure: None

HYG Junk Bond ETF Continues Lower As Oil Prices Fall

The high-yield junk bond ETF (NYSEARCA: HYG ) continues to trend lower, and Monday’s drop of 0.7% left it at a new multi-year low. As HYG’s price moves lower, its yield moves higher, but at 5.8%, the yield is still half of what it was at the start of the equity bull market in early 2009. Investors look for the “risky” equity market to trend in the same direction as the junk bond market, but clearly that hasn’t been the case over the last 18 months or so. As “junk” has fallen, the S&P 500 has continued to trend slightly higher. The reason is because of the drop in oil prices. High-yield debt in the Energy sector accounts for a large portion of the drop in the broad high-yield debt market, but stock price drops in the Energy sector haven’t been enough to move the needle significantly lower for the broad S&P 500. Below is a chart of the price of oil compared to the HYG junk-bond ETF. They have tracked each other very closely recently. We covered this topic in more detail in Monday’s Chart of the Day (subscription required). (click to enlarge)

Money Markets On The Money With $10.3 Billion Gain

By Patrick Keon Lipper’s fund macro-groups (including both mutual funds and exchange-traded funds [ETFs]) had aggregate net inflows of $8.6 billion for the fund-flows week ended Wednesday, September 23. This activity marked the second consecutive week of overall positive flows; the groups took in $4.7 billion of net new money the prior week. Money market funds (+$10.3 billion) saw the largest net inflows this past week, while municipal bond funds (+$231 million) also experienced positive flows. Equity funds (-$2.0 billion) suffered the largest net outflows, while taxable bond funds had net outflows of $33 million for the week. The S&P 500 Index (-56.55 points) and the Dow Jones Industrial Average (-460.06 points) were down 2.83% and 2.75%, respectively, for the week. Both indices suffered the lion’s share of their losses during two trading days (Friday, September 18 and Tuesday, September 22). The major market news of the week was the Federal Reserve’s decision to leave interest rates unchanged. Despite an improving U.S. labor market, Fed Chair Janet Yellen cited the inflation rate (which is significantly below the 2.0% target) and global growth concerns (China) as the reason for keeping rates where they are. The Fed’s inaction was the main impetus for the losses incurred by the indices, as it created fear about the depth of China’s economic problems and uncertainty about when the Fed will raise rates. In an attempt to jawbone the market, Atlanta Fed President Dennis Lockhart said he still expects the Fed to hike rates later this year because of stronger jobs data outweighing the below-target inflation rate. The statement achieved its desired result (at least temporarily), with the market posting gains on the day of the statement (Monday, September 21) before retreating again on Tuesday, September 22, on renewed concerns about the slumping global economy. The net inflows for the week into money market funds (+$10.3 billion) broke a three-week string of net outflows for the group, which saw almost $29 billion leave its coffers. Institutional money market funds accounted for the entirety of the net inflows this past week, taking in just over $13.0 billion of new money. Equity ETFs were responsible for all of the net outflows (-$4.9 billion) for the week, while equity mutual funds had $2.9 billion of net inflows. Non-domestic equity funds took in the majority of the net new money (+$2.2 billion), while domestic equity funds contributed $673 million to the total. The SPDR S&P 500 Trust ETF ( SPY , -$8.3 billion) was responsible for all of the net outflows on the ETF side. In a reverse of the equity fund activity, taxable bond mutual funds (-$1.4 billion net) had money leave, while ETF products had $1.3 billion of net inflows. Lipper’s Core Bond Funds classification (-$2.3 billion net) was by far the largest contributor to the outflows on the mutual fund side, while for ETFs the iShares 20+ Year Treasury Bond ETF ( TLT , +$414 million) and the iShares iBoxx $ High Yield Corporate Bond ETF ( HYG , +$212 million) had the two largest net inflows. Municipal bond mutual funds took in $322 million of net new money, breaking a streak of four straight weeks of net outflows. Funds in Lipper’s national municipal bond fund group contributed $338 million of net inflows to the total, while single-state municipal bond funds saw $16 million leave.