High Yield ETF’s – Everything you need to know…

As we all know, an investment in an Exchange Traded Fund (ETF) offers an instant measure of risk diversification as it represents an interest in a pool of financial assets or securities. This helps particularly when you are planning to invest in an asset where the risk is higher than normal.

One particular security in the basket can go belly up and it will not significantly affect the value of the basket. In theory, therefore, you should be able to find a better than average yield in an ETF without running the risk of putting your money in a single high dividend paying stock or a single high yield bond.

High yield ETF’s normally fall into three categories: equity-based, property-based and bond-based. Since many of these ETF’s are denominated in different currencies, you could also profit from currency appreciation. For instance, many ETF’s based on European equities have performed well because of the strength of the Euro. In many cases, investors had to decide whether the currency gain is worth the trade-off against slightly lower yields.

In the case of bond-based ETF’s, there is the currency question but there are also other issues to be addressed. Some of the best performing bond-based ETF’s have been based on emerging country debt but you have to be happy with the underlying risk. A lot of the popular high yield ETF’s are currently based on so-called “junk bonds”. This is debt that issued by companies which have a credit rating less than investment grade. As The Motley Fool so aptly put it “one man’s trash is another man’s treasure”.

To be fair, many junk bonds are acceptable credit risks. In fact in 2008 and 2009, many junk bonds were hammered on price in the expectation that there would be large-scale default on corporate debt. This kind of corporate Armageddon simply did not happen and many ETF’s that are based on these bonds have performed spectacularly as a result.

Certainly, because of the risk diversification, an ETF is seen as an appropriate route to investment in high yield bonds.

High yield ETF’s versus high yield mutual funds: high yield ETF’s have attracted billions of dollars in investment in the past several months reflecting the keenness of investors on high yield (driven in part by the poor performance of the equity markets) as well as their growing confidence in the economic recovery. Mutual Funds have however competed fiercely for investor dollars and launched a number of successful funds. ETF’s however have the following advantages:

-ETF’s adopt a passive investment style while mutual funds are active investors. Mutual funds necessarily have to depend on savvy investment managers and their costs are therefore that much higher. Mutual funds also charge fees for short-term investments of less than 90 days. All this means that mutual fund yields are lower.

-an ETF offers the advantage of trading like stock which means that it can be traded all day, traded on margin to acquire leverage and amenable to risk management measures such as limit orders.

A reasonable compromise might be to use ETF’s for short-term trading and mutual funds for long-term investment.You may also consider ETF Trend Trading to improve your returns.