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The Trouble With Indexing High-Yield Bonds

Neutral-rated Xtrackers USD High Yield Corporate Bond ETF illustrates the challenges of indexing the junk-bond market.

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Xtrackers USD High Yield Corp Bd ETF

Xtrackers USD High Yield Corporate Bond ETF HYLB tracks a market-value-weighted index that is more broadly representative of the investment opportunity set in the high-yield bond space than those underpinning some of its exchange-traded fund peers. At 0.15%, it boasts one of the lowest fees in the high-yield bond Morningstar Category. That said, being beholden to a benchmark means that issuance activity will dictate the fund's makeup, which in this market segment often results in greater credit risk. Additionally, liquidity filters prevent it from fully capturing the opportunities available to active peers. These considerations support its Morningstar Analyst Rating of Neutral.

The strategy tracks the Solactive USD High Yield Corporate Bond Index, which includes U.S.-dollar-denominated fixed-rate corporate bonds rated below-investment-grade with between one and 15 years remaining until maturity and at least $400 million of outstanding face value. The index is weighted by market value, which mitigates turnover and tilts the portfolio toward the largest issues.

High-yield bonds are illiquid and expensive to trade, which can make them hard to index efficiently. It's tougher to mitigate tracking error and transaction costs in the high-yield bond market than it is in the investment-grade corporate-bond market, as high-yield bonds tend to be more thinly traded. This strategy attempts to circumvent that problem by limiting its holdings to the most liquid high-yield bonds. However, this prevents the fund from fully representing its opportunity set.

Additionally, the case for market-value-weighting high-yield bonds is not as strong as it is for investment-grade bonds because this approach pulls the strategy toward the most heavily indebted issuers, which are vulnerable to changes in the business cycle and may not be priced to offer the best returns for their risk. While risk and return are highly correlated in the fixed-income markets, investors in search of yield turn to the high-yield bond market, which can cause the prices of these issues to deviate from their intrinsic value.

In other areas of the bond market, like investment-grade corporate bonds, the largest issuers tend to have less credit risk because they have the resources to meet their obligations. But in this opportunity set, the resulting portfolio consists of issuers that are highly sensitive to the economy and are thus susceptible to large drawdowns during periods of tumult.

Active management is probably a better option here because those managers have greater flexibility to manage liquidity and credit risk. Sound fundamental credit research can exploit mispricing, which is likely more common here than in the investment-grade market given that there is a greater amount of uncertainty about future cash flows.

Process This portfolio replicates the composition of the U.S.-dollar-denominated below-investment-grade corporate-bond market, harnessing the market's view on the relative value of each bond. However, active management is probably a more prudent way to invest than indexing given these issues' illiquidity and uncertain cash flows. To address the liquidity challenges of this market, the index limits its focus to the most liquid part of the market, which helps, but doesn't completely resolve this issue. And this filter prevents the fund from truly reflecting the composition of the market. Accordingly, the fund earns a Below Average Process Pillar rating.

The strategy employs representative sampling to track the performance of the Solactive USD High Yield Corporate Bond Index, which includes U.S.-dollar-denominated corporate bonds rated below-investment-grade with between one and 15 years remaining until maturity. Qualifying bonds must have at least $400 million of outstanding face value; this makes the index easier to track and reduces transaction costs, which are high in this market. The index is rebalanced monthly. This yields a risky portfolio that is not fully representative of the corporate high-yield market because of the liquidity screen.

The portfolio takes considerable credit risk. As of March 2020, nearly 10% of the fund's assets that were in debt rated CCC or lower. As a result, it will be vulnerable to large drawdowns during periods of tumult, when credit spreads widen, and the market demands greater compensation for credit risk.

The fund's holdings mostly reflect the composition of the high-yield market, but that's not necessarily how actively managed funds in the category build their portfolios. For example, relative to the category average, the strategy is about 10% overweight in issuers from the consumer cyclical and the corporate communication sectors, and about 10% underweight in securitized debt, senior loans, and equities. Many actively managed funds sprinkle in some exposure to investment-grade bonds to help shore up liquidity and to better protect against downturns.

This strategy's broad reach effectively diversifies concentration risk. The fund's top 10 holdings constitute less than 5% of its total portfolio, so a small number of issues won't necessarily detract from performance, which is a risk for some actively managed funds that take larger stakes in individual issuers.

The fund's interest-rate risk is in line with its category peers. As of March 2020, its average effective duration was about three years.

People This team earns an Average People Pillar rating because its talented portfolio managers have kept this fund performing relatively tightly to its index, despite the inherent difficulties in the high-yield market. The team has remained stable since the fund's inception in 2016, but it is not as large or well-equipped as industry leaders, and there is less independent oversight.

Bryan Richards, Tanuj Dora, Brandon Matsui, and Alexander Bridgeforth have acted as the fund's portfolio managers since its inception. Richards heads the firm's passive portfolio management department and is primarily responsible for supervising the team, while Dora acts as the primary lead portfolio manager for this strategy. DWS employs a team approach to minimize key-person risk, so Matsui and Bridgeforth are both heavily involved as co-lead portfolio managers, and they assist Dora with the fund's daily management. All three acting lead portfolio managers had prior experience with trading or portfolio management prior to joining DWS.

When needed, the team relies on support from the 10 high-yield analysts who work on the actively managed team. While this ensures that the portfolio managers are always on top of their funds, the team's size could be a disadvantage. The high-yield bond market is large, diverse, and risky, so solid credit analysis can help a portfolio manager better navigate the idiosyncratic risks of the opportunity set.

DWS maintains an investment risk committee that meets monthly as part of its independent review of the fund. And while compensation is determined based on a variety of factors including how closely funds perform to their benchmarks, portfolio managers set their own benchmark-tracking goals.

Performance The fund's performance was solid from its inception in December 2016 through March 2020. During that time, it beat the category average by 75 basis points while exhibiting less volatility. As a result, its risk-adjusted performance ranked in the category's best third. The fund's rock-bottom fee helped as its annual expense ratio is almost 60 basis points less that its typical category peer.

While its performance thus far has been strong, the strategy follows debt-issuing activity, which may not always lead to good results. For example, it was overweight the consumer cyclical sector ahead of the coronavirus crisis, a sector that was hit particularly hard given the shock to consumer demand. As a result, the fund's maximum drawdown was more severe than the category average; it fell by 21.11% from Feb. 19, 2020, through March 23, 2020, while the category average fell by 20.11%.

As an index fund in an illiquid market, the strategy will struggle to perform tightly to its benchmark during periods of stress. For instance, from the fund's inception in December 2016 through February 2020, it trailed its benchmark by 2 basis points per month. However, it beat its benchmark by 45 basis points in March 2020 amid the liquidity crunch caused by COVID-19.

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About the Author

Neal Kosciulek

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Neal Kosciulek is a manager research analyst, passive funds research, for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. He covers fixed-income exchange-traded funds and mutual funds.

Before joining Morningstar in 2019, Kosciulek spent five years as an examiner with the Financial Industry Regulatory Authority, conducting sales practice and financial operational examinations of broker/dealers across the country.

Kosciulek holds a bachelor's degree in economics from DePaul University's Driehaus College of Business. He also holds a Master of Business Administration from DePaul University's Kellstadt Graduate School of Business.

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