HYLD: Exceptionally High Yields Create Some Substantial Risks

| About: AdvisorShares Peritus (HYLD)

Summary

HYLD delivered excellent performance as an actively managed junk bond fund until things fell apart in 2014.

The fund has a very active style with a high expense ratio as it aims to do solid due diligence on its investments and pick better bonds.

The yield on the fund would be exceptional so long as the underlying bonds don’t default.

The AdvisorShares Peritus High Yield ETF (NYSEARCA:HYLD) is an interesting ETF. The high expense ratio concerns me, but the other aspects of the fund are very attractive. It will be interesting to see if it can come back from the losses it suffered. The enormous drop off would make investors think that it was a sector falling, but the sector exposure is surprisingly diversified.

Strategy

HYLD uses a very active approach to portfolio management. Rather than simply investing in the more liquid securities and relying on the market to create efficient pricing, HYLD is selecting its portfolio to create a high-yield income stream through a focus on the secondary market where the fund believes the market is less efficient.

How Well The Strategy Worked

Using the fact sheet for the fund, I pulled up its chart of returns on a hypothetical investment. The returns looked fairly solid at first, and the fund was able to keep up with the Barclays US Corporate High Yield TR USD index. Everything was going great until late 2014. Then, that concentrated risk kicked in and hammered returns.

Click to enlarge

That huge orange line that was doing so well is the fund. As you can see, in late 2014, the returns practically fell off a cliff and began trailing all of the comparable measures.

Expenses

Some funds are able to offer low expense ratios and mitigate their risks by strictly dealing in the most liquid bonds where pricing is most likely to be efficient and relying on the market to ensure that the risk/return profile is appropriate. Generally, I favor ETFs that have low expense ratios and strictly deal in highly liquid bonds where the pricing will be more efficient.

HYLD is the opposite of that strategy. The fund runs with a high expense ratio and deals in illiquid bonds with a goal of earning enough to offset the expense ratio through its expertise in evaluating the assets. The expense ratio for HYLD is 1.23 %. Until late 2014, investors could easily argue that the fund deserved a higher expense ratio due to the great returns. Unfortunately, being aggressive enough to cover that expense ratio requires a substantial amount of risk. When it backfires, you can get the kind of substantial losses that happened to HYLD.

Yield

The yield is massive. The desire for a higher yield should be fairly easy for investors to understand. Bond funds that offer a higher yield are offering more income to the investor. Unfortunately, returns are generally compensating for risk, so higher-yield funds will usually require an investor either take on duration risk or credit risk.

In this case, the risk is an overwhelming credit risk:

The coupons are fairly high, but the yield to maturity is incredible. If the companies all actually make the required payments on their bonds, the result would be an exceptional return to shareholders. Even that 1.23% expense ratio wouldn't be able to stop the massive return from a yield to maturity of almost 16%. The major issue that could interfere is the possibility of defaults or bonds that are sold at an enormous discount due to an expected default.

Sectors

The following chart demonstrates the sector exposure for this bond fund:

The irony here is that the fund indicated that the risk would be focused. Since the fund only lists 84 holdings, it is certainly feasible to say that the fund's holdings are concentrated, but they are not overwhelmingly concentrated by industry. Given the dramatic drop in the share prices, I would have assumed that it was substantially exposing itself to commodity price risk by holding debt issued by high cost oil producers or mining companies. In each of those industries, the expectation for defaults would have sent bond prices crashing.

Conclusion

The fund suffered from a large setback, and the high expense ratio is enough to push me away. For investors willing to take on the risk, the potential yields are exceptional. Seeing the enormous decline during 2014 reinforces my reasons for focusing on a passive bond portfolio strategy that emphasizes highly liquid securities. When there are only 84 underlying investments, the potential damage from default is quite significant.

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.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.