Active ETF Option For Junk Bond Exposure (HYLD)

by on December 21, 2010

The ETF industry took flight nearly two decades ago, an addition to the investing landscape spurred by disappointment with traditional actively managed mutual funds and interest in developing more flexible tools consistent with an index-based strategy. Though the very first ETF was built with traders in mind, ETFs quickly emerged as an ideal fixture for “buy and hold” portfolios. ETFs have exploded onto the scene in recent years, with over 1,100 products now available and plenty more on the way. As the popularity of these investment tools has grown, so too has their reach in today’s markets. The average investor can now obtain exposure to a number of asset classes that would otherwise not be available using the exchange traded structure. One of the most promising and newest frontiers in the ETF industry is the actively-managed space, a corner of the market that combines the flexibility and efficiency of the exchange-traded structure with the attempt to generate excess returns [see also Seven Wildly Successful Active ETFs].

Despite a number of academic studies showing that active management fails to consistently add value, “alpha hunting” remains one of the great American pastimes. Research shows that managers will fail to beat their benchmark as much as 80% of the time (after considering costs), leading many seeking exposure to very liquid and efficient asset classes to pursue indexing strategies. Yet there are corners of the market where some investors are more comfortable with the idea of having the expertise of an experienced manager. These can include emerging and markets and the high risk / high return world of junk bonds.

The actively-managed world has been slow to gain traction as far as ETFs are concerned, but with more of these products hitting the market, it is clear that there is interest in these funds is still growing. The new Peritus High Yield ETF (HYLD), the result of a partnership between AdvisorShares and Peritus Asset Management, is the first actively-managed ETF to focus on high yield debt, and just the fourth U.S.-listed ETF available in this often intimidating but potentially lucrative segment of the fixed income space. But the lack of an underlying index isn’t the only thing that makes HYLD unique; the management team behind this fund has a different approach to investing in high yield corporate debt [see also ETF Alternatives To The World’s Largest Mutual Funds].

Under The Hood

The fund will be managed by Timothy Gramatovich, who started his career at Drexel Burnham and whose experience working around the bankruptcy arena in the Los Angeles federal courts system helped to shape an innovative investment strategy. Gramatovich manages the Peritus portfolios along with Ronald Heller, a former NFL tight end who started his finance career at Smith Barney and went on to co-found Peritus. Unlike many fixed income managers who use credit ratings as a critical part of their investment philosophy, Peritus gives the scores assigned by S&P and Moody’s little to no consideration; it is their view that debt is either AAA or D, meaning that it will either pay out or it won’t.

HYLD is also designed to be more selective than indexed junk bond funds that hold the entire market. For example, the Peritus team generally stays away from debt issued in connection with the pre-2008 wave of highly leveraged LBO’s, which may carry excessive risk in the current environment. The team will also refrain from buying bonds directly from issuers, waiting instead to purchase securities on the secondary market. This strategy could allow the managers to get a better understanding of the market’s perception of a bond’s worth, allowing shrewd managers to better exploit inefficiencies in the marketplace.

The underlying investment thesis also focuses on the idea of “diversification vs. deworsification”, meaning that simply diversifying a portfolio is not useful if the correct investments are not chosen. And the flexibility of the fund isn’t limited to selecting individual securities or themes within the junk bond space; HYLD maintains the flexibility to shift exposure into Treasuries when spreads narrow and the outlook for the high yield debt space deteriorates. Such a strategy can obviously be valuable if managers are able to identify periods of turbulence for junk bonds, but can backfire if yield is sacrificed (by shifting to safer securities) but junk bonds continue to perform well [see Recapping A Wild Week In The ETF World].

High Yield Space Surging

HYLD will be the latest entry into an asset class that has been among the best performers of the last several year and continues to attract investor interest. With interest rates near record lows and expected to remain depressed for the foreseeable future, many investors have become more creative in their hunt for current returns. For some, that search has led to dividend-paying stocks or MLPs, while others have embraced a larger allocation to junk bonds in teh fixed income portion of their portfolios [see also ETFs For The Forgotten Asset Classes].

HYLD will feature 40-60 holdings at any given time, and allocations to various sectors will change along with the fund managers’ views on which corners of the market are most promising. Currently, debt from Opti Canada and Gibson Energy are among the largest holdings, though individual holdings can change frequently [investors can see the complete list of holdings at any time on the AdvisorShares' website]. The target yield for HYLD will be in the 8%-10% range, and many of the current holdings pay coupons of 10% or more [see also PHB: Different Kind Of Junk Bond ETF].

For investors looking to beef up their exposure to junk bonds but uncertain that simple indexing is the most efficient strategy, HYLD may be worth a closer look. The combination of an experienced management team and the inherent efficiency and liquidity of the exchange-traded structure creates a unique opportunity for investors who subscribe to the Peritus approach to junk bonds. Perhaps the biggest question mark surrounding the new fund is the expense ratio; at 1.35%, HYLD is considerably more expensive than the other options in the Junk Bond ETFdb Category (the average is 0.69%, and JNK charges just 0.4% in total annual fees.

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Disclosure: Photo courtesy of John Wiley. No positions at time of writing.