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A New High-Yield ETF Choice

Also, Schwab launches Treasury ETFs.

Patricia Oey, 08/09/2010

For the year to date, high-yield ETFs have been among the top 10 categories in asset inflows, with most funds flowing into the two popular high-yield ETFs--SPDR Barclays Capital High Yield Bond JNK and iShares iBoxx $ High Yield Corporate Bond HYG, each of which has more than $5 billion in assets under management. A third high-yield ETF, PowerShares Fundamental High Yield Corporate Bond PHB, has been a relative underperformer, both in terms of total returns and in asset inflows. On average, high-yield funds are currently paying yields near 10%, but at this time, given the tepid recovery outlook for the U.S. economy, we think an investment in highly leveraged companies to be suitable primarily for the most risk-seeking investors.

Last week, PowerShares changed the underlying index for its high-yield ETF from an equal-weighted index to a fundamentally weighted index and changed the name of the fund to PowerShares Fundamental High Yield Corporate Bond from PowerShares High Yield Corporate Bond Portfolio. The new underlying index, the RAFI High Yield Index, which was developed by Research Affiliates, uses fundamental measures including sales, dividends, cash flows, and book value to set constituent weights. According to PowerShares, this index construction methodology provides heavier exposure to firms that are better able to service its debt, versus traditional bond indexes, which are weighed by the market value of debt outstanding and thus are more exposed to the larger debtor companies. Not surprisingly, the average credit rating of PHB's constituents is somewhat higher than that of JNK and HYG, but the average duration across the three funds is almost the same. Research Affiliates' has provided annualized three-year, five-year, and 10-year return data for its RAFI High Yield Index of 10.2%, 8.7%, and 10%, which is above that of BarCap High Yield Very Liquid Index's (the underlying index for JNK) 6.4%, 7.2%, and 7.3%. The JNK fund continues to be the cheapest (expense ratio of 0.40%) and the most liquid of the three high-yield ETFs. HYG and PHB each charge 0.50%.PAGEBREAK

Schwab Adds Bonds to Its ETF Lineup
Last week, Schwab introduced its first bond ETFs:

Schwab Short-Term U.S. Treasury ETF SCHO
Schwab Intermediate-Term U.S. Treasury ETF SCHR

The expense ratios for these funds (0.14%, 0.12%, and 0.12%, respectively) are the lowest relative to comparable ETFs from competitors such as iShares and SPDRs. Both SCHP and SCHO track the same index as iShares Barclays TIPS Bond TIP (expense ratio 0.20%) and iShares Barclays 1-3 Year Treasury Bond SHY (0.15%), respectively. SCHR tracks Barclays Capital U.S. 3-10 Year Treasury Bond Index, which makes it very similar to the comparable iShares Barclays 3-7 Year Treasury Bond IEI (0.15%), which tracks the Barclays Capital U.S. 3-7 Year Treasury Bond Index.

At this time, inflation expectations are low, which could suggest that now may be an appropriate time to purchase TIP funds, or "inflation insurance," at a reasonable price. However, as for short- and intermediate-term Treasury ETFs, given these funds' extremely low yields at this time, we don't think there is a lot of room for price appreciation for these types of funds. Please refer to our iShares reports for our fundamental view on these asset classes and details on the underlying indexes.

The Schwab ETFs would be attractive to Schwab customers, as they can buy and sell these ETFs without trading commissions. Those not on the Schwab platform will incur trading costs, and we note that these new Schwab bond ETFs' bid-ask spreads will be wider than those of the more established iShares ETFs in the near term--this indirect trading cost would easily offset the small difference in expense ratios between the Schwab and iShares funds.

Other Launches
On the heels of last month's launch of Van Eck's Emerging Markets Local Currency Bond ETF EMLC, WisdomTree Emerging Markets Local Debt ELD begins trading today. The fund will look to tap into the success of EMLC, which is already up to $36 million in assets since its July 22 launch. No less than 80% of the assets of the ELD will track emerging-markets debt through derivative contracts such as forward currency agreements and total returns swaps, and it will invest its cash in high-quality, U.S. money market instruments. As much as 20% of the fund may be invested in U.S.-dollar-denominated debt of emerging-markets issuers.

The fund may invest in both investment-grade and non-investment-grade debt and will cap country exposure at 20%. Duration will be kept between 2.0 and 7.0 years. Unlike EMLC, which tracks the JP Morgan GBI-EMG Core Index, ELD will be actively managed through a quantitative approach. The fund plans to charge an expense ratio of 0.55% compared with 0.49% for EMLC.

Patricia Oey is an ETF analyst with Morningstar.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

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