High-Yield Bonds: The One Place Not to Own an ETF

Finally, passive strategies may have limited exposure to the entire high-yield market due to the liquidity constraints of the category. Given the lack of market transparency, many passive strategies use market sampling, which excludes smaller bond issuances and doesn't accurately capture large parts of the market. Smaller size issuers can offer attractive investment opportunities for active managers that have the flexibility to invest along the credit spectrum and have the necessary credit analysis capabilities. According to data from JPMorgan, more than $1.9 trillion of new high-yield bond issuance occurred between 2008 and 2014. Of this amount, just over 15%, or $290 billion, was issued by companies in the energy sector. This credit boom from energy companies to finance expansion efforts has caused the high-yield energy sector to grow from 10% of the Bank of America Merrill Lynch High Yield Master II Index at the end of 2007 to nearly 15% at its peak in 2014. For perspective, the energy sector of the S&P 500 Index was only at 8.4 percent at the end of 2014. As a result, as oil prices began to fall in the second half of 2014, high-yield issuers concentrated in the energy sector saw the worst performance of any bonds in the market, only to be followed by the best performance this year, exceeding emerging market debt returns through April, as oil prices found support and began to recover.

Source: Morningstar, as of 4/30/2016

A large number of high-yield funds that employ active management have significantly outperformed the US High Yield ETF bond category average during the three years ending April 30, according to Morningstar.

It's clear that investors have regained their appetite for higher-yielding assets. This year, fixed-income investors have been returning to high-yield bond allocations, investing $2.31 billion in April alone and over $13.8 billion year to date, according to Morningstar. For calendar year 2015, as well as January and February this year, flows into passive high-yield funds far outpaced flows into active ones. Only recently have active high-yield funds begun to take in more flows than passive – perhaps a sign that investors are starting to see the benefits of active management in the high-yield space. As any good long-term investor knows, costs associated with buying and selling diminish potential returns and seriously hamper the potential for alpha generation in a well-balanced portfolio. Investors should think twice about owning high-yield ETFs for their "perceived" lower costs. Those costs add up quickly and may sacrifice the very performance investors seek in the long term.

— Andrew Wilson, manager of U.S. research & analytics, and Amber Milam, associate director/investment director, both of Henderson Global Investors, also contributed to this report.