The iShares iBoxx $ High Yield Corporate Bond ETF (ticker: HYG) is the largest U.S. High Yield ETF in terms of AUM, with more than $14 billion of assets as of 11/17/14. The management fee for HYG is 50bps annually. Is this cheap? Is it expensive? We believe that two questions are imperative in forming a conclusion:
- What are the options for expressing your view in high yield?
- Where do you fall in the strategic-tactical continuum? Expressed in another way, how often do you plan on turning over your high yield position?
In terms of question #1, there are really three options worth considering in this conversation: ETFs, mutual funds or underlying bonds.
As an asset manager, we immediately rule out mutual funds due to cost, intra-day liquidity, transparency and other issues.
Underlying bonds, on the other hand, can be problematic in certain product wrappers. For example, a 20% allocation to high yield in a $100,000 SMA obviously would be impossible to implement with underlying bonds since HYG has 999 holdings.
However, if we assume that we are talking about large, centralized vehicles such as a mutual fund where this type of ETF replication is feasible, then we are down to two options: ETFs and underlying bonds.
To simplify the discussion, we will assume that we are able to perfectly track the ETF with underlying bonds. In this case, cost becomes the most important consideration. We incur trading costs, both commission and bid/ask spread related, with both ETFs and bonds. The ETF has the added cost of the embedded management fee. For simplicity, since commissions can be highly dependent on execution venue, we will focus on bid/ask spread and management fee.
In order to compare ETF and bond costs on an apples-to-apples basis, we introduce two concepts:
- Breakeven Trades Per Year – As we will discuss in a bit, bid/ask spreads for fixed income ETFs tend to be lower than bid/ask spreads for the underlying bonds. The more times a position is traded, the bigger the cost advantage of using ETFs becomes. The breakeven trades per year is the annual number of trades such that this cost advantage completely offsets the ETF’s management fees. If a firm trades the position more (less) than the breakeven trades per year, then the ETF will be less (more) expensive, all-in.
- Trade-Adjusted Management Fee – The trade-adjusted management fee is the effective ETF management fee after adjusting for the trade-related cost advantage of ETFs. This number is calculated assuming a certain number of trades per year. Generally, the trade-adjusted management fee will be lower as the number of trades per year increases, since more trading means increased savings from utilizing the ETF’s tighter bid/ask spread.
As we mentioned previously, the management fee for HYG is 50bps. In “The Bond Investor’s Guide to ETFs,” iShares quoted the average bid/ask spread for HYG at 1bps and the average bid/ask spread for the underlying bond basket at 40bps.
The breakeven trades per year can be calculated by dividing the ETF management fee by half of the difference between the average bid/ask spread of the underlying bond basket and the bid/ask spread of the ETF. For HYG, the breakeven trades per year is 2.6.
The trade-adjusted management fee is calculated by first multiplying the expected number of trades year by half of the difference between the average bid/ask spread of the underlying bond basket and the bid/ask spread of the ETF and then subtracting this amount from the ETF management fee. For HYG, the trade-adjusted management fee is 31bps for one trade per year, 11bps for two trades per year, and -9bps for three trades per year. A negative trade-adjusted management fee indicates that the all-in cost of the ETF is less than that of the underlying basket at that trading frequency.
Below, we outline breakeven trades per year and trade-adjusted management fees for some of the larger iShares fixed income ETFs using data from “The Bond Investor’s Guide to ETFs.”
Breakeven Trades Per Year By ETF
Trade-Adjusted Management Fee By ETF (bps)
While these metrics are overly simplistic and ignore what we feel are other compelling benefits to ETFs, they do a good job of putting ETF management fees into a useful context for ETF selection. For example, this framework could be used to justify holding a “more expensive” ETF from a management fee perspective but one that offers enhanced liquidity in the form of tighter bid/ask spreads.