How is it possible that so few active high yield managers outperform their index, and that passive managers lag theirs by more than their management fee? Our research shows that a high yield index is not a useful benchmark for evaluating portfolio returns, and that an alternative approach is needed.
High yields come at a cost
High yield corporate bonds offer several attractive investment features, such as coupon rates and returns that are higher than that of investment grade assets. This comes at a cost, of course. This sector of the credit market also presents challenges for investors, such as limited liquidity, defaults, rating migrations and bonds that are callable before maturity. These characteristics imply a variety of costs that are not reflected in the index returns. The underperformance of passively managed ETFs, for instance, illustrates the difficulties of generating index-like returns in the high yield market.
As long as indices do not contain all the costs that accrue in practice, high yield indices are not a fair reflection of the potential returns from a high yield credit portfolio. This means that they are not suitable as benchmarks for evaluating fund manager performance.
What would be a better performance yardstick?
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Our recommendation for investors in high yield funds is to compare portfolio performances with one another, rather than with an index.
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