A Focused High Yield ETF: What Could Go Wrong?

| About: AdvisorShares Peritus (HYLD)
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Summary

Disaster at an actively managed high yield ETF demonstrates the importance of fund structure when selecting investments.

Understanding the liquidity of the underlying securities is paramount to selecting the right fund structure (i.e. ETF, CEF, open-ended mutual fund, etc.).

Ignoring liquidity constraints of the lower grade high yield market has created an ongoing liquidity crisis for HYLD and significant losses for shareholders.

Below is a NAV chart for the actively managed, focused high yield ETF: Peritus High Yield ETF (NYSEARCA:HYLD). The last few months have been simply disastrous.

Anyone unfortunate enough to wander into this ETF recently is probably wondering, "What in the world happened to my high yield allocation??? I thought high yield was still positive this year!!" And, "Wait a minute, aren't ETFs supposed to trade nearly at NAV?" Thankfully, some answers are available on the asset manager's website in the recent centerpiece video. A few points in the script stand out: the manager's attraction to energy credits, the fund's concentrated investment style, and the manager's confidence in his ability to profit from more illiquid credits while citing other high yield ETF's lack of competition in this space as a competitive advantage. Lucky him.

We can blame the large energy allocation (currently 27% of the fund) on just a bad market call. Everyone makes them. Hopefully, for the sake of our portfolios, we each admit to them in time and get out. The problem in this case is an inappropriate fund structure that impedes a clean exit for fund investors and creates a growing crisis for remaining fund investors. There is a clear mismatch between the perceived liquidity of the ETF and the liquidity of the underlying high yield bond holdings.

ETF's are a very attractive investment vehicle for minimizing capital gains in long-term equity portfolios, and they are a very attractive trading and tactical allocation vehicle. I'm a big fan of ETFs. However, an ETF's attractiveness in these cases is due to the underlying liquidity of their markets. The ease at which a market maker for the ETF can arbitrage away any discount or premium to the ETF's underlying NAV is largely what makes the ETF an appropriate structure. Conversely, a frequently illiquid underlying securities market (i.e. lower rated high yield) can wreck havoc on a fund during a bear market/period of elevated redemptions.

Quarter to date (QTD) alone, the Fund is nearly down 14%. Its small equity position has been absolutely hammered, but the high yield positions have contributed to the largest portion of the drawdown.

HYLD disclosed that two of it's junk bonds defaulted in its September 2014 newsletter (download file on Peritus home page). HYLD liquidated these - likely at fire sale prices - because it could not participate in the workout/reorganization process. It will be interesting to see what other defaults may have taken place at the end of the quarter. The takeaway here is that HYLD is being forced to liquidate it's bond portfolio in the most inopportune, value destructive way due to the ETF structure that demands instant liquidity. The majority of the ETF's corporate debt issues are now rated "CCC", and the spreads on the portfolio have completely blown out. The OAS on this portion of the portfolio is well over 1,000bps according to Bloomberg Valuation. The weighted average maturity of the debt issues is about 4 years, so the solvency of many of the underlying companies is about to be called seriously into question. Can they refinance? Given that the average coupon is 9.4%, and these bonds are trading at a YTM of ~13.5%, the majority of these issues are trading well beneath par. This is clearly a portfolio full of highly distressed situations.

Buying illiquid, small issue, high coupon, junk bonds can be a lot of fun on the way up as it was for the shareholders of HYLD. Money is easy to make in a bull market. Being one of the only active, focused high yield funds is a cool marketing strategy for quickly attracting a lot of assets. Where this structure falls apart, though, is in providing instant liquidity to fund shareholders making immediate redemptions. Trading becomes highly problematic when a fund owns relatively few, smaller bonds issues as the portfolio manager described the fund's strategy in the link at the beginning of the article.

HYLD's problems began around the time oil began its plummet. The ETF's assets were cut in half in a matter of months, and the pace of outflows has accelerated.

It's not hard to imagine the series of events that have been unfolding as millions of dollars in assets have been redeemed from HYLD in a very short space of time in some of the most illiquid segments of the high yield market. Banks don't exactly make a market in that stuff anymore. Market makers can't even find enough inventory to arbitrage a 6% and growing discount to NAV (first chart). And, the discount/problem has been growing since early December despite a collapsing NAV that is far worse than the experience in the broader high yield market. That's when you know it's bad. An ETF is only as liquid (without taking a significant hit to NAV) as its underlying assets. Investors and asset management firms that ignore this principal will learn it during the next panic.

Bear markets in high yield are part of the investment cycle. Their timing is notoriously hard to predict. They occur suddenly, resulting in violent sell-offs as spreads blow out, defaults rise, and liquidity dries up. Investors who have not traded the underlying securities in high yield markets and assume that an ETF structure provides easy liquidity will be in for a rude surprise during the next major high yield wash out. We are getting a taste of what that will look like in the high yield energy sector courtesy of HYLD.

If you can't predict the investment cycle, be sure to at least pick the appropriate fund structure to manage liquidity. Closed-end funds (CEFs) are ideally suited to the high yield sector given the lack of redemptions in this fund structure. Open-ended mutual funds with daily liquidity may also be appropriate if the manager primarily restricts his/her investing to the more liquid, high quality securities in the high yield market and maintains adequate liquidity. But for high yield, the lesson here is don't bother with ETFs - especially focused ETFs that play in the most illiquid portion of the high yield debt market.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.