Comparing and Contrasting High Yield Indices
How will the iBoxx index, and by extension HYG, compare against broader high yield indices? It really depends on the performance of those smaller issues in the market. If those issues are doing well, the iBoxx index will likely trail indices like Barclays and Merrill that represent the broad market. And if larger issues are doing better, then iBoxx should lead. One other important difference between iBoxx and other indices: iBoxx includes the transaction costs of monthly rebalancing in the index return calculation. In other words, all else being equal, iBoxx would likely show a lower return. This means the iBoxx index returns are calculated more similarly to an actual high yield bond portfolio, which would also incur transaction costs.
If you think about it, this large versus small difference is very similar to what we find in the equity markets. The Russell 1000 Index represents large cap equity names, while the Russell 3000 Index includes those same names plus 2000 smaller issues. As such, we wouldn’t expect Russell 1000 and Russell 3000 to perform the same. Russell 1000 does well when large cap names outperform, and would be expected to trail the broad Russell 3000 market when large cap underperforms smaller issues. This is the same in the high yield market. We expect the iBoxx index to outperform broader indices like those from Barclays or Merrill during some markets, and trail in others.
As many active high yield mutual funds invest in the smaller high yield bonds, the comparison is similar. But many of those mutual funds may also invest in sectors outside the high yield market such as bank loans, convertible bonds and preferred stock as a way of seeking to outperform their index. As of 9/30/15 the high yield mutual funds in Morningstar’s universe had an average of 2.3 percent equity holdings. Comparing the iBoxx index to these funds isn’t a case of apples versus oranges; it’s a case of apples versus an entire fruit basket. We would expect performance differences through time. As of 10/31/2015 HYG had outperformed 51 percent of active mutual fund managers over the prior 5 years. (This is according to Morningstar; HYG’s performance was compared to the performance of the A-Share classes of all managers in the Morningstar US Open-Ended High Yield Bond Category.) It landed right in the middle, better than some funds in the market and worse than others.
The Bottom Line: Deciding What’s Best for Your Objectives
To be fair, not all high yield ETFs perform the same, and this comparison is only for HYG. Investors who use other ETFs would have to crunch the numbers to see if those funds performed in a similar way.
It’s not a question of whether index or active is “better” or “right”, but rather a question of what kind of exposure you seek. If you want to go with the fruit basket and you can find a good active manager who you believe can generate outperformance, then an active mutual fund may be the right choice. If you prefer to have more control of your investment and want to invest only in high yield bonds, then a high yield index fund may be the right choice—you are giving up the potential gains from one of the 49 percent of managers who outperformed the ETF, but also avoiding the potential losses from picking one of the 51 percent who didn’t. Either way, pick the investment that matches your investment style and investment objectives.