More disruptions and innovations are needed in creating bond ETFs.
Existing smart beta and factor-based bond ETFs show varied track records.
We want a deep understanding of how these ETFs are designed.
We also want to look into their past performances.
ANGL is solid on both counts, but PHB presents a lousy return/risk profile.
There are only about 375 fixed income ETFs in the U.S., according to ETF.com. Among them, only a few applied fundamental factor strategies when picking and weighting securities. The VanEck Vectors Fallen Angel High Yield Bond ETF (NYSEARCA:ANGL), whose inception date is April 10, 2012, and PowerShares Fundamental High Yield Corporate Bond Portfolio ETF (NYSEARCA:PHB), whose inception date is Nov. 15, 2007, stood out after my research work on these types of bond ETFs. ANGL became my favored pick, while PHB became disliked.
First, I juxtaposed the basic metrics such as AuM, expense ratio, average spread, and number of holdings to get a sense of these two funds.
Comparing the two above, it seems PHB is better on cost to purchase (expense ratios of 0.3 and 0.35, respectively), as well as on liquidity (average spread of 0.05% and 0.08%, respectively). In addition, with almost half the duration of ANGL (PHB’s is 3.8 while ANGL’s is 6.2), PHB should give investors a lower volatility too.
How about their past performance? Using ETFReplay.com, I plotted the chart of their total return with SPDR S&P 500 Trust ETF (NYSEARCA:SPY) and iShares Core Total U.S. Bond Market ETF (NYSEARCA:AGG) as benchmarks.
I plotted the chart of PHB’s full 10-year performance history below, and you can see the lousy return/risk profile. Its total return is much lower than the hodgepodge basket of AGG, 35.5% vs. 51.5%, while the volatility tripled that of AGG. In terms of the fancy smart beta or fundamental weighting, PHB clearly falls far behind its benchmark. Some might wonder why, if the duration of AGG is 6.7 — almost double that of PHB — is the volatility of PHB is not half but triple that of AGG?
I then dove into the indexes that ANGL and PHB track to understand more. PHB tracks the RAFI Bonds U.S. High Yield 1-10 Index. According to its methodology, it’s comprised of U.S. dollar-denominated bonds issued by U.S.-listed companies. Each issue must be rated Ba1/BB+ or lower by either Moody’s or Standard & Poor’s, but not below B3/B- by either Moody’s or Standard & Poor’s.
What differentiates this index from the rest is the RAFI-score-based weighting schema. In traditional size-based weightings, a company is rewarded or assigned a higher weight just because of a larger amount of debt this company is willing or dares to issue. The RAFI Bonds U.S. High Yield 1-10 index designer saw the flaw and took a very different approach. They calculate a score that is based on four factors: gross sales, gross dividends, cash flow, and current book value of assets. In doing so, the quality of the debt is not only rated by the agencies (Moody’s and Standard & Poor’s), but also scrutinized by objective financial statements. It’s theoretically a sound and plausible method. However, the return — about 3% annualized — in the past 10 years is disappointing, and the total volatility of 15.9% — close to SPY’s 20.6% — is even more unacceptable.
Switching to ANGL, the benchmark of ANGL is the BofA Merrill Lynch U.S. Fallen Angel High Yield Index. The innovation of this index is not about weighting, but about picking out a special basket of companies that are “fallen angels.” Per a VanEck document, “fallen angels” are those originally issued as investment grade corporate bonds, but have since been downgraded to non-investment grade (high-yield) bond status. Fallen angels are mostly large companies that have solid credit quality and financial solidness historically. Once fallen, they have the strongest will and urge to fight back and attain their high-grade status again.
This innovative bond indexing method is well-embraced by the market, evidenced by the fact that ANGL, issued by VanEck in April 2012, has accumulated almost $1 billion in five years. A similar fund, iShares Fallen Angels USD Bond ETF (NASDAQ:FALN) — issued by BlackRock in 2016 — is gaining ground by cutting the expense ratio to 0.25% (compared to ANGL’s 0.35%). ANGL’s popularity is not only based on its sound thesis, but also on the well-established performance record. From the first chart above, we can see its cumulative total return is 54.2%, almost five times that of the bond benchmark AGG’s 11.4%, and with a reasonable volatility. (I didn’t cite the volatility value from ETFReplay.com as there was an idiosyncratic spike near the end of 2013 for ANGL, skewing the standard deviation calculation.)
In conclusion, I favor ANGL and dislike PHB even though both are based on solid fundamental theories. Investment is a practical world, and the past can’t be used to predict the future, but we frequently reference the past to avoid those that faltered or are still fumbling.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.