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ETFs: Passing Marks For Liquidity, But What About Performance?

By Alliance Bernstein Proponents of credit exchange traded funds (ETFs) claim the last week of market turmoil was a test for these instruments-and that they passed. We think this takes grading on a curve to a new level. The cheerleaders say ETFs succeeded because they traded regularly after a high-yield mutual fund failed and barred investor withdrawals. Here’s what they’re not telling you: in exchange for this liquidity, investors ended up with instruments that have woefully underperformed active mutual funds-recently and over many years. For long-term investors who are saving to pay for college or retirement, that’s an awfully steep price to pay for something they don’t really need. The numbers speak for themselves: Over the first 11 months of this year, the two largest ETFs – HYG and JNK – have sharply underperformed the average active manager, not to mention their own benchmarks. They’ve also trailed the average active manager so far in the fourth quarter ( Display ) and since the start of December, one of the year’s most volatile months so far. ETFs’ longer-term performance falls short, too. In fact, not only have active managers outpaced ETFs over the long run, they’ve done it with lower volatility, as measured by risk-adjusted returns. The Sharpe ratio, which measures return per unit of risk, was 0.45 for JNK and 0.51 for HYG between February 2008, shortly after they began trading, and November of this year. For the top 20% of active high-yield managers, it was 0.71. How Much Liquidity Is Enough? Is the ability to get in or out of an ETF at any point in the day worth the underperformance? For asset managers and traders who need to trade frequently to hedge positions, maybe. After all, they’re not investing in these instruments as long-term income generators. But a large share of the people who own high-yield ETFs aren’t traders. They’re regular folks saving for college, or to buy a new home, or for retirement. In other words, they’re investors, not traders. Most probably aren’t doing any intraday trading at all. If they’re buying ETFs for the liquidity, they’re paying-dearly-for something they don’t need. In our view, an actively managed mutual fund is likely to offer higher potential returns over the long run – and give investors a better chance of meeting their goals. In fact, the data suggest that investors who want long-term exposure to high yield would do better to pick an active manager out of a hat than invest in an ETF. With Mutual Funds, Diversification Is Key All well and good, some investors are no doubt thinking. But what happens when mutual funds fail? That’s a fair question. Liquidity is important for everyone, as the failure of Third Avenue Management’s Focused Credit Fund illustrates. But it’s important to remember that this mutual fund was not a typical high-yield fund. It focused almost exclusively on risky distressed debt issued by highly leveraged companies. These types of assets are relatively illiquid, and that became a problem when large number of investors wanted to sell their shares. In other words, investors were promised “daily liquidity”-the ability to buy or sell shares in the mutual fund at the end of each trading day-but the assets the mutual fund owned could not be bought or sold on a daily basis. These types of strategies are bound to fail eventually. Most high-yield managers follow more diversified strategies that focus on a wide array of higher-quality assets. Of course, investors should still make sure their investment managers have a dynamic, multi-sector approach and are managing their liquidity risk effectively . Those who do a good job will be in position to meet redemptions during downturns and seize opportunities as they arise . That’s something Third Avenue couldn’t do. High-yield ETFs can’t do it, either . The recent turbulence in the high-yield market probably isn’t over. But we don’t think that should concern long-term investors too much. In our view, the best approach at this point is probably to ride out the storm. The intraday liquidity ETFs offer comes at a high price-and if you’re a long-term investor in high yield, you shouldn’t be paying it. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Disclosure: None

Asset Class Weekly: From The High-Yield Bond Battlefront

Summary Capital markets are under fire. Just two weeks ago, Asset Class Weekly focused on the troubles that were brewing in the high-yield bond market. What a difference two weeks make. A growing number of creditors in the high-yield bond market are fighting for survival. Capital markets are under fire. Just two weeks ago, Asset Class Weekly focused on the troubles that were brewing in the high-yield bond market. What a difference two weeks make. For while many investors are getting ready to settle in for the holiday season, a growing number of creditors in the high-yield bond market are fighting for survival. Given the rapid pace of the descent in high-yield bonds over the past two weeks, it is worthwhile to check in with the latest from the high-yield bond market. It was almost exactly one year ago in December 2014 that I first began sounding the alarm about the stresses building in the high-yield bond market. At that time, the sharp decline in oil since the summer of 2014 and in particular since the OPEC meeting that came the day after Thanksgiving last year had the high-yield bond market starting to question the long-term viability of selected names in the universe. At the time, nearly all of the names under pressure in the high-yield bond space came from the oil patch. And the measure of stress at the time was the fact that 13 publicly-traded companies in the high-yield bond universe as measured by the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA: HYG ) had bonds were trading at a 25% to 50% discount to their par value while another 22 publicly-traded companies had bonds that were trading at a 10% to 25% discount to par. On December 12, 2014, when I published this first high-yield bond (NYSEARCA: JNK ) article, the stock market as measured by the S&P 500 Index closed at 2,002.33. As of the end of last week on December 18, 2015, the S&P 500 Index closed at 2,005.55. But while the headline stock market index might imply that not much has changed over the past year, oh so very much has changed underneath the market surface. And nowhere is this more true in a chronically bad way than in the high-yield bond market. Once again for emphasis, we had 13 creditors with bonds trading at a 25% to 50% discount to par and another 22 companies with bonds trading at a 10% to 25% discount to par almost exactly a year ago at this time. And this was a sign of building stress. So where exactly are we a year later? Today, we have 27 publicly-traded companies with bonds trading at a 25% to 50% discount to par. Sure, this is roughly double where we were at this time last year, but not so bad, right? Au contraire. W hile this 25% to 50% discount group was considered the front lines of high-yield bond market stress, this is the relatively better side of the story today. Triage Let’s begin. We have had a handful of companies in the high-yield bond space that have since either entered into bankruptcy or have creatively restructured in a grasp for survival. We also now have 11 publicly-traded companies that are trading at a more than 75% discount to par. In short, these are firms that have been badly wounded in operational battle and are now in financial market triage fighting for their lives. Arch Coal (NYSE: ACI ) BreitBurn Energy Partners (NASDAQ: BBEP ) Chesapeake Energy (NYSE: CHK ) Cliff Natural Resources (NYSE: CLF ) Energy XXI (NASDAQ: EXXI ) Linn Energy (NASDAQ: LINE ) Peabody Energy (NYSE: BTU ) Penn Virginia (NYSE: PVA ) Seventy Seven Energy (NYSE: SSE ) Ultra Petroleum (NYSE: UPL ) Verso ( OTCQB:VRSZ ) It should be noted that the list above is not at all from the fringes of capital markets as names like Chesapeake Energy and Ultra Petroleum are among the larger players in the energy space. The Front Line In the next group on the list, we have another 18 publicly-traded companies in the high-yield bond space whose bonds are also trading at a highly stressed 50% to 75% discount to their par value. These include the following: AK Steel (NYSE: AKS ) California Resources (NYSE: CRC ) CHC Group (NYSE: HELI ) Comstock Resources (NYSE: CRK ) Denbury Resources (NYSE: DNR ) EXCO Resources (NYSE: XCO ) Genworth Financial (NYSE: GNW ) Halcon Resources (NYSE: HK ) Intelsat (NYSE: I ) Memorial Production Partners (NASDAQ: MEMP ) Midstates Petroleum (NYSE: MPO ) Navios Maritime (NYSE: NM ) Pacific Drilling (NYSE: PACD ) Sanchez Energy (NYSE: SN ) SandRidge Energy (NYSE: SD ) Transocean (NYSE: RIG ) U.S. Steel (NYSE: X ) Vantage Drilling Company (NYSEMKT: VTG ) It is worth noting that seven companies descended into this group within the last two weeks. This includes California Resources, Denbury Resources, Intelsat, Memorial Production Partners, Midstates Petroleum, Sanchez Energy and Transocean. A number of the names on the above list are also meaningful players in the energy space. And the list is also not limited to just names in the energy space, as we also have communications, retail, industrial and consumer products companies now also showing up on this front line distressed list. Preparing For Battle: The Second Wave In the next group on the list, which was formerly the front line just one year ago, we have as mentioned above 25 publicly-traded companies in the high-yield bond space that are trading at a 25% to 50% discount to par. These companies currently under fire include the following: Advanced Micro Devices (NASDAQ: AMD ) Allegheny Technologies (NYSE: ATI ) Antero Resources (NYSE: AR ) ArcelorMittal (NYSE: MT ) Avon Products (NYSE: AVP ) Bombardier ( OTCQX:BDRBF ) Chemours (NYSE: CC ) CONSOL Energy (NYSE: CNX ) DCP Midstream Partners (NYSE: DPM ) Energy Transfer Equity (NYSE: ETE ) iHeartMedia ( OTCPK:IHRT ) Navistar International (NYSE: NAV ) Oasis Petroleum (NYSE: OAS ) ONEOK (NYSE: OKE ) Precision Drilling (NYSE: PDS ) Range Resources (NYSE: RRC ) QEP Resources (NYSE: QEP ) Scientific Games (NASDAQ: SGMS ) SM Energy (NYSE: SM ) Sprint (NYSE: S ) Talen Energy (NYSE: TLN ) Tronox (NYSE: TROX ) Whiting Petroleum (NYSE: WLL ) Windstream (NASDAQ: WIN ) WPX Energy (NYSE: WPX ) In addition to this list above that includes some eye-opening names, two notable retailers that are currently not publicly traded but are also now listed among this group. These are Neiman Marcus (Pending: NMG ) and Toys “R” Us. But perhaps more troubling than this list from the high-yield space is the suddenly expanding list from the investment-grade corporate bond universe as measured by the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA: LQD ). Just three weeks ago at the end of November, only one name (Freeport-McMoRan (NYSE: FCX )) made this 25% to 50% discount to par list. Today, once again just three weeks later, there are 13. These are listed below: Barrick Gold (NYSE: ABX ) Cenovus Energy (NYSE: CVE ) Continental Resources (NYSE: CLR ) Devon Energy (NYSE: DVN ) Ensco (NYSE: ESV ) Energy Transfer Partners (NYSE: ETP ) Enterprise Products Partners (NYSE: EPD ) Freeport-McMoRan Kinder Morgan (NYSE: KMI ) Newmont Mining (NYSE: NEM ) Southwestern Energy (NYSE: SWN ) Viacom (NASDAQ: VIA ) Williams Companies (NYSE: WMB ) It is one thing to see signs of credit stress in the high-yield bond space, but it is another thing altogether when these pressures begin to spread in the investment grade space. Overall, these lists combined bring us to 40 publicly traded or notable companies that are trading at a 25% to 50% discount to par. Bottom Line Perhaps this is all just a short-term phase in the bond market. It is possible that we are near or at a bottom and these increasingly stressed bond prices will soon start bouncing higher. Maybe, but probably not. The deterioration in the high-yield bond space has been brewing for some time. And it has picked up dramatically in the past couple of weeks with the magnitude of the price declines in many names across the high-yield bond spectrum well in excess of -20%. The fact that the problem has now started to spread to the investment-grade bond space is even more problematic, as it suggests that a broader cleansing process may now be at work. And the next time we regroup to explore this list, it seems highly probable that we will add a whole new cast of characters, as scores of names now reside in the 10% to 25% discount to par list that have not even bothered to explore here that are also experiencing accelerating price declines in their own right. Lastly, this decelerating pace of credit deterioration is taking place in an environment where the U.S. Federal Reserve just raised interest rates off of the zero bound for the first time since the outbreak of the financial crisis. While I applaud the Fed for finally showing the courage to act, it is unfortunately doing so far too late at this point. Thus, for those analysts and experts that are calling for another year of positive U.S. stock market gains in 2016 despite the fact that stock valuations are already hovering at historically high levels, unless we see the Federal Reserve do a complete about face and start pouring liquidity back into financial markets (do not rule this possibility out over the next 12 months), we may find ourselves with results that are decidedly different than positive for stocks this time next year. Special Notice : As many readers have likely seen by now, I also provide a premium service on Seeking Alpha called The Universal . The service targets winning investment portfolio strategies across the asset class universe in both bear and bull markets with a focus on attractive return opportunities, risk control and loss minimization. The Universal includes timely asset allocation models, weekly strategy updates, targeted stock watch lists, feature articles and specific buy/sell recommendations. It is also a forum for real-time updates and analysis during periods of heightened market stress. The Universal currently costs $29 per month or $239 per year to subscribe. But starting on January 1, 2016, the subscription cost for The Universal will increase to $39 per month or $299 per year. Existing subscribers as well as those who sign up by December 31, 2015, however, will continue to pay the lower $29 per month or $239 per year rate. As a result, if you are interested in trying my premium service and have not already joined, I encourage you to sign up before the end of the year to lock in the lower rate. And if you are concerned that the service may not be a good fit, you are protected by Seeking Alpha’s unconditional prorated money-back guarantee. Questions about The Universal? Send me an e-mail at anytime and I will respond with answers to your questions. Thanks, and I look forward to collaborating with you on The Universal. Disclosure : This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

Asset Class Weekly: The Junk Inside High Yield

Summary High yield bonds were conspicuously absent from the capital market rally on Friday. It is worthwhile for investors to take a look under the hood and consider exactly what they are getting when they are buying into high yield bond market. Risks remain biased to the downside for the asset class. Global capital markets had a marvelous trading day to close out the week on Friday. Almost everything traded strongly higher to close out the week including widely divergent categories such as U.S. stocks (NYSEARCA: SPY ), U.S. Treasuries (NYSEARCA: TLT ), gold (NYSEARCA: GLD ) and copper (NYSEARCA: JJC ) all posting robust gains. But one asset class was conspicuously absent from the party on Friday. It was high yield bonds (NYSEARCA: HYG ), and the fact that this category could not even squeeze out an incremental gain with the rest of the market surging raises an eyebrow to say the least. Given that so many income starved investors such as retirees have found themselves increasingly allocating to this category in recent years in the desperate search for yield, it is worthwhile to take a look under the hood and consider exactly what investors are getting when they are buying into high yield bond market. High Yield Bonds: Not Your Grandma’s Bond Market Many investors fall victim to a common misconception. Stocks are exciting and bonds are boring. Stocks are for those interested in achieving capital growth, while bonds are a safe way to invest and earn some income. Thus, when they see the word “bonds” included in the “high yield bonds” moniker, they make the assumption that these investments are safer than being allocated to stocks. And professionals having thrown around statements like “historically low default rates” in the recent post crisis years has only served to reinforce this potential misconception that high yield bonds are a generally safe place to park your money and capture a meaningfully higher yield. But this is not the case when it comes to high yield bonds. In fact, high yield bonds behave much more like stocks than traditional bond categories like U.S. Treasuries. For example, since the outbreak of the financial crisis in 2007, the high yield bond market has had a +0.74 returns correlation with the S&P 500 Index versus a -0.11 returns correlation with the U.S. Treasury market. In other words, high yield bonds more often than not follow the returns path of the U.S. stock market, not the traditional bond market. This strong relationship between high yield bonds and stocks, not Treasuries, is demonstrated in the following historical returns chart during the financial crisis. For while stocks were plunging lower and U.S. Treasuries were rallying, high yield bonds followed the stock market lower. And when stocks bottomed and started rallying in March 2009 as U.S. Treasuries were cooling, high yield bonds began to rally sharply along with the stock market. (click to enlarge) When High Yield Bonds Become Junk OK, so high yield bonds act more like stocks than bonds. In many market environments, this is a wonderful characteristic that makes them an ideal asset class to own as part of a diversified portfolio strategy. And the name “high yield bonds” certainly sounds welcoming enough. Hey, one might say, I’m making an investment in a bond that is going to earn me a higher yield. Indeed, this is true. But there is no free lunch when it comes to investing or anything else. These bonds are providing investors with a higher yield for a reason. And when it comes to high yield bonds, this higher yield is more often than not due to the fact that an increased default risk is associated with the bonds. After all, these bonds were once widely known as “junk bonds” for good reason. Of course, investing in something that is called “high yield” is a lot more appealing than something that is called “junk”. And the threat is starting to build that they may once again make good on their old fashioned name. During periods of economic prosperity, the default risk associated with high yield bonds (NYSEARCA: JNK ) is typically low. This can also be true during periods of freely flowing liquidity in the financial system. Unfortunately for investors, these low default rate periods can breed complacency, for it does not take long once underlying economic and/or financial market conditions to deteriorate before junk bond default rates start spiking higher. For example, during the period from 1992 to 1998, the default rate on high yield bonds was consistently less than 2%. But after moving meaningfully higher in 1999 and 2000, the default rate spiked toward 13% in 2001 and over 16% in 2002. Putting this in perspective, one out of every eight high yield bonds defaulted in 2001, and for those remaining issuers that did not default in 2001, one out of every six defaulted the next year in 2002. Putting this in yet another perspective, imagine having a ladder of six attractively yielding certificates of deposit (CDs) at your local bank and learning at some point in time that one of these CDs would only be getting paid back at 40 cents on the dollar, or maybe even less, or perhaps hardly at all. From 2004 to 2007, high yield default rates returned to lows below 4%. But once the financial crisis began to set in, credit risk began to explode higher once again. In 2008, the high yield default rate pushed toward 7% and by 2009 it was spiking toward 14%, or one out of every seven high yield bonds. These default rate swings are nothing new for the asset class, for they have been known to periodically occur going all the way back to when they were first entered into the capital markets mainstream leading up to what is now referred to as the junk bond crisis of 1989. None of this is to say that high yield bonds are not an outstanding asset class that has their place in a broader asset allocation strategy. But like many categories they have their periods over time of strength and weakness. And high yield bonds are among those that are exposed to greater risk, particularly event risk, than many other categories due to their reliance on lower quality credit issuance. And it seems that we may be increasingly moving toward such a period of weakness for the category today. Where Are We Today? Today, high yield bonds have returned to their sanguine ways. Since 2010, the default rate has remained consistently below 3%. That is, of course, until 2015 when this rate has crept higher toward the 4% level. Is this recent shift higher in default rates foreshadowing more trouble ahead? Only time will tell, but one has to look no further than the option adjusted spreads of lower quality high yield bonds over the past year. This trend certainly does not bode well, particularly since the high yield bond market does not have a Fed frantically rushing to the rescue like in 2011. Instead, they have a Fed that remains determined to raise interest rates. (click to enlarge) This helps explain why the high yield bond market had not participated at all in the recent stock market rally. For while both U.S. stocks and high yield bonds had been moving lower generally in lockstep with one another since the stock market peak back in May, they began to diverge in late October with stocks rallying higher while high yield bonds continued to falter. For U.S. stock investors, this recent deviation should be troubling, as failure in the high yield bond market has been known to spill over by eventually applying downside pressure to other asset classes including stocks. (click to enlarge) What Junk Is Inside My High Yield Bond Portfolio, Anyway? So what exactly are investors getting when they buy into the high yield bond market. Let’s take a look at some of the individual names. The following are some of the largest holdings from the iShares iBoxx High Yield Corporate Bond ETF. HCA (NYSE: HCA ) Ally Financial (NYSE: ALLY ) Frontier Communications (NASDAQ: FTR ) Sprint (NYSE: S ) Tenet Healthcare (NYSE: THC ) Navient (NASDAQ: NAVI ) Clear Channel Outdoor (NYSE: CCO ) Together, these eight companies make up 12%, or roughly one-eighth, of the high yield bond market by this ETF product’s measure. Included below are the recent stock price charts for these same securities. Also included for good measure is the stock price chart of Linn Energy (NASDAQ: LINE ). While this credit does not rank among the top ten holdings in the HYG, it in many respects serves as a poster child for the challenges that over the past year have plagued the energy sector, which makes up 13% of the entire high yield bond market. Why are we looking at the stock prices of these companies whose bonds are included in the HYG? Because the stock price still represents the market’s view on these companies. And if the stock price is falling precipitously enough, it begins to also make a statement about how investors perceive the liquidity and solvency of the company going forward. (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) What we see from the above charts are representative companies from the high yield bond market that have seen their stock prices recently fall anywhere between -20% to -95%. This raises several key points. First, signs of underlying weakness in high yield are no longer confined to the energy space. The list of companies shown on the above slide set are sourced from a diverse array of industries. And they are all performing poorly to varying degrees. Second, the extreme price volatility along with the sudden sharp downside across a range of high yield bond names including those shown above should at least raise questions about the suitability of a major allocation to high yield bonds in the portfolios of many retirees. Given the characteristics of the stocks of these companies, are these the types of names that are best suited for those investors that cannot sustain a measurable loss in value. Lastly, one could understandably counter the point above by stating that investors are putting money into the bonds of these companies, not the stock. Thus, by moving up the capital structure they are protecting themselves from the extreme downside risk associated with holding the stock. Indeed, this is true, but only to a point. For yes an investor is better served to move up the capital structure to hold a credit that will likely have some residual value in the event of a bankruptcy instead of holding the equity and receiving nothing, but for the investor that can ill afford to see as many as one out of every six credits in their bond portfolio enter into default, getting paid thirty to forty cents on the dollar at best is little consolation for people like retirees that are living on fixed incomes and cannot tolerate exposure to downside even remotely near these levels. Sure, these discounts can provide great upside opportunities for investors in the know, but for many retirees, they are not necessarily well positioned or suited to engage in the art of distressed debt investing with their retirement savings. Recommendations The high yield bond market is finding itself increasingly under fire. It has been steadily weakening in recent weeks despite the broader stock market rally. And underlying fundamental conditions for the asset class continue to deteriorate. While the last several years during the post crisis period have proven kind to the asset class, default rates are now creeping higher. As a result, it stands to consider as we move toward the end of 2015 and into 2016 whether high yield bonds will make good on their previous identity as junk. For more conservative investors, now continues to be a reasonable time to consider scaling back existing exposures to the high yield bond market. For the more assertive investor, a short allocation (NYSEARCA: SJB ) to the high yield bond market may have increasing appeal as conditions in the junk bond market continue to unfold. Disclosure : This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.