Investors love passive ETFs. After all, using an index fund is a great way to receive cheap beta and liquid exposure to an asset class. ETFs make it easy to build an entire diversified portfolio with just a few tickers. And you can do so for pennies on the dollar in terms of management expenses. It’s no wonder why trillions of dollars now sit in passive index ETFs from retail and institutional investors alike.
However, some investors choosing passive investing may be missing out on gains in certain asset classes.
One of those happens to be junk bonds. For investors choosing passive high-yield ETFs, they risk missing out on a substantial portion of the potential returns offered by these investments in the first place. Active ETFs remove this limitation and should be the only game in town for junk bonds.
Index ETFs Miss Out
It’s easy to understand why indexing is favored by so many investors. Beating the ‘market’ is hard so it’s far easier to own the entire thing and let long-term compounding work its magic. Exchange traded funds have exacerbated this fact. They offer dirt-cheap costs and easy one-ticker access. Trillions in investor capital have flown into ETFs as portfolio construction tools.
One area where plenty of investor capital has flown has been in the area of high-yield or junk bonds.
High-yield bonds are issued by firms with less than investment-grade credit ratings. Typically, junk bonds are rated BB or lower by Standard & Poor’s and Ba or lower by Moody’s. While the ratings feature some gray areas, the gist is there is some risk of default or issues could prevent payback of the bonds. Because of this, they feature higher yields than investment-grade bonds. They function differently than regular bonds as well, providing a strong total return/equity-like ride for portfolios.
Because of the enhanced risks involved with the asset class, many investors have chosen to get their junk bond allocations through passive means. The largest three junk bond ETFs hold nearly $50 billion in assets.
But what works for one asset class may not work for another. The active/passive debate isn’t so clear cut when it comes to junk. Just take a look at this chart from asset manager John Hancock. As you can see, passive doesn’t actually match the index and underperforms.
Source: John Hancock
It’s About the Benchmark
Now, it’s easy to say, “Of course, the ETF doesn’t match and will underperform the benchmark. There are fees!” And you’d be right, to a point. However, the difference in performance is more than the ETFs’ underlying costs. There are a few other factors at work.
For one thing is the underlying passive ETFs’ construction.
Assets under management play into just how ETFs are constructed. Because of the size of many passive funds, many sponsors have selected high-yield indexes that focus on narrower benchmarks that comprise the largest and most liquid high-yield bonds. Or they use a sampling approach to replicate the index. After all, it’s easier for authorized participants (APs) to buy enough of a highly liquid bond to create new shares of the ETF than a smaller issue.
This comes down to bid-ask spreads for junk bonds. These bonds are traded over-the-counter, less frequently, and with higher bid-offer spreads. Bank of America data shows that at the end of 2024, the effective bid-ask spread for the high-yield market was averaging roughly 31 basis points (bps). That’s a wide spread when most S&P 500 equities trade at fractions of pennies. Moreover, firms will often issue multiple bonds at the same time with varying coupons, maturities, and rankings within the issuer’s capital structure. This adds more complexity to the high-yield market and can make it difficult for APs to arbitrage what’s in the ETF during the creation and redemption process. 1
According to John Hancock, this reduces returns and potential value of smaller issuers or less-familiar bonds. 2
Then there is the fact the passive funds are forced to be static in their construction.
The win of indexing is you get the good along with the bad. But because you’re forced to take both sides, you are always skirting down the middle. In the high-yield market, this can be a problem as sector location matters greatly to overall returns in a typical business cycle, as does credit quality. Once again, an index doesn’t maintain any difference on credit quality or nuances between gradings. However, relationships between higher- and lower-quality borrowers can present significant opportunities for investors.
The thing is active managers don’t have to deal with these sorts of issues even when it comes to ETFs.
Active managers can conduct credit and cash flow research into the underlying firms. This allows them to avoid pitfalls and defaults before they happen. Moreover, they can buy bonds at discounts to their value or at slightly greater spreads than average to provide a larger safety and, perhaps, increased yields.
The end result is better performance. Data shows that returns of active managers in the high yield space—as provided by NASDAQ subsidiary eVestment—shows the average manager outperform the three largest passive ETFs over one-, three-, five-, and 10-year periods.
Active ETFs for Junk
Thanks to poor index construction, lower liquidity, and the ability of high-yield managers to do credit research, the choice is clear. Investors looking to add a touch of high-yield bonds to their portfolio are better suited in active strategies than they are in passive ones.
By using an active ETF, investors can get all the benefits of active management while still maintaining low costs. And luckily, there have been numerous active ETF launches within the junk bond sector.
Active Junk Bond ETFs
These funds are selected based on their ability to access high-yield bonds with an active touch. They are sorted by their YTD total return, which ranges from 1.3% to 4.7%. Their expense ratio ranges from 0.22% to 1.02%, while they have AUMs between $50M and $5.63B. They are currently yielding between 5.7% and 8.6%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| FLHY | Franklin High Yield Corporate ETF | $268M | 4.7% | 5.7% | 0.40% | ETF | Yes |
| YLD | Principal Active High Yield ETF | $160M | 4.7% | 7.2% | 0.39% | ETF | Yes |
| HYBL | SPDR Blackstone High Income ETF | $136M | 4.4% | 8.2% | 0.70% | ETF | Yes |
| THYF | T. Rowe Price U.S. High Yield ETF | $50M | 4.1% | 7.5% | 0.56% | ETF | Yes |
| SRLN | SPDR Blackstone Senior Loan ETF | $5.63B | 3.8% | 8.6% | 0.70% | ETF | Yes |
| FTSL | First Trust Senior Loan Fund | $2.27B | 3.8% | 7.5% | 0.87% | ETF | Yes |
| BKHY | BNY Mellon High Yield Beta ETF | $292M | 3.4% | 6.9% | 0.22% | ETF | Yes |
| PHYL | PGIM Active High Yield Bond ETF | $124M | 3.4% | 8.2% | 0.39% | ETF | Yes |
| HYFI | AB High Yield ETF | $123M | 3.4% | 6.7% | 0.40% | ETF | Yes |
| HYLS | First Trust Tactical High Yield ETF | $1.43B | 1.3% | 6.4% | 1.02% | ETF | Yes |
In the end, active management and active ETFs can provide a serious edge in the world of high-yield/junk bonds. Those choosing indexing could actually underperform their benchmarks by a wide margin as structural reasons hurt performance. The choice is clear and that active wins.
The Bottom Line
Many investors choose junk bonds to boost their yield and do so via a passive index fund. However, that isn’t always the right choice. Active management allows investors to get all the benefits and returns of the sector.
1 Pinebridge (February 2025). Why High Yield Bonds Call for an Active Investing Approach
2 John Hancock(May 2025). Why passive ETFs might be forfeiting some of high yield’s return potential
