Some investors may have noticed deviations in the way junk bond exchange traded funds track benchmark indices. However, the perceived discrepancies in their respective tracking performances may be a result of indexing quirks.
The iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) and SPDR Barclays High Yield Bond ETF (NYSEArca: JNK) are the two popular junk bond-related ETFs, with a combined $25 billion in assets under management. HYG tries to reflect the performance of its benchmark Markit iBoxx USD Liquid High Yield Index. JNK tracks the Barclays High Yield Very Liquid Index.
“After adjusting for its 0.50% expense ratio, HYG actually outperforms its benchmark on a gross basis,” writes John Gabriel, a strategist for Morningstar’s manager research team. “On the other hand, JNK appears to lag its index by a relatively wide margin – a gap far too large to be explained only by its 0.40% expense ratio.”
Specifically, comparing HYG’s performance to its benchmark, the iShares ETF has exhibited a -0.49 percentage point difference year-to-date and a -0.21 percentage point difference for the past five years.
In contrast, comparing JNK’s performance to its underlying index, the State Street fund showed a -1.46 percentage point difference year-to-date and a -1.13 percentage point difference over the past five years.
Contributing to the slight variations in the ETFs’ ability to track their benchmarks, the two fund providers follow different portfolio construction and economic exposures, along with varying costs and tracking efficiency. Additionally, JNK has a greater liquidity constraint, setting minimum outstanding face value on debt securities at $500 million, compared to the $400 million limit in HYG.
However, the main reason JNK is showing wider tracking errors may be due to the different indexing methodologies.
“The discrepancy in tracking error may largely boil down to a subtle difference in how the indexes are calculated,” Gabriel said. “To be clear, I’m not referring to the composition of the benchmark (that is, which bonds are included and at what weighting), but rather how bonds in each index are priced. The price at which a bond enters or exits the index is a critical detail. The same goes for when existing constituents are bought and sold in the monthly rebalancing process.
David Mazza, head of research for ETFs at State Street Global Advisors, attributes JNK’s underperformance to transaction costs. When an ETF rebalances its portfolios to better track the underlying index, the fund must buy or sell debt securities. While iBoxx absorbs some of the transaction costs, Barclays indices does not, which may help explain JNK’s poorer performance to its benchmark. [The Hidden Costs Of Junk Bond ETFs]
JNK’s underlying Barclays High Yield Very Liquid Index prices all transactions at the bid price, whereas HYG’s Markit iBoxx USD Liquid High Yield Index marks existing and exiting bonds at the bid price and new holdings that enter the index at the ask or offer price.
“In effect, by pricing incoming bonds on the ask side, transaction costs are embedded in the Markit index that HYG tracks,” Gabriel added. “As a result, HYG should be expected to have minimal (if any) tracking error. In contrast, JNK would be expected to lag its benchmark by (at least) its transaction costs, given that Barclays index does not reflect the cost of the bid-ask spread associated with actually buying and selling a particular bond.”
Once investors compare apples-to-apples by calculating both indices by similar transaction costs, both funds have actually tracked their benchmarks reasonably well, according to Morningstar data.
For more information on the speculative-grade debt market, visit our junk bonds category.
Max Chen contributed to this article.