Saturday, March 22, 2014

Volatility - Corporate High Yield Bond Funds: ETF vs. Mutual Fund

[Note: This article has been updated since originally posted]

We thought it would be interesting to provide a simple chart-based example of how volatility varies on a relatively short-term basis between a corporate high yield bond mutual fund and an ETF (exchange traded fund).  Below is a graph showing year-to-date daily closing prices for a mutual fund (NHINX) and an ETF (HYG).

(click chart to enlarge)
NHINX vs. HYG: year-to-date volatility comparsion

The following excerpt from the HYG prospectus (effective date 7/1/2013) helps illustrate the nature of premiums and discounts (note that the table will vary from year to year based on market conditions - the table currently reflects a period of high demand): 

(click table to enlarge)
Excerpt from HYG Prospectus Describing Premium/Discount Range

In contrast to the ETF, a mutual fund's NAV/share is based only on the value the individual holdings in its portfolio and is not affected by market supply and demand for shares.

Volatility differences between ETFs and mutual funds may also be affected by the nature of the trading/investing populations. Since ETFs are subject to intraday trading on exchanges, price movements may be driven by a mix of longer-term investors and short-term traders/speculators, including momentum traders and day-traders. Short-term traders may be attracted to ETFs because of the volatility and the fact that they trade below and above NAV, allowing these traders an opportunity for enhanced short-term gains.

In contrast, mutual fund shares are purchased through various dealers (e.g., banks, brokerage firms, workplace retirement programs, financial advisers), or in some cases directly from the mutual fund company, and are not subject to intraday market price variations. Thus, mutual fund price movements are most likely determined by investors with a longer-term perspective.

There are other considerations for why you would want to invest in an ETF versus a mutual fund, which will be covered in other articles. In any case, higher volatility is one important reason we do not generally invest in high yield bond ETFs, corporate or otherwise.  

We have a relatively long-term perspective. As such, we prefer to hold as long as possible (as market conditions allow) and to keep transactions (and associated costs) to a minimum (several per year). 

Compared to mutual funds, it has been our experience that the increased volatility and associated intraday price movements of ETFs make it more difficult (i.e., resource/time intensive and error-prone) to manage risk and realize capital gains using chart-based technical analysis.

Also, we have not forgot what happened on May 6, 2010 - the so-called "flash crash", which could happen again for a variety of reasons (see related Forbes article - "Why we could easily have another flash crash").

Thus, for both practical (and ethical) purposes, the relatively "boring" (i.e., calm, slow-moving) nature of high yield mutual funds suits us just fine.  

There was a time when we used intraday price action of HYG, and two other corporate bond fund ETFs (JNK, and PHB), along with other technical evidence of course, on days when we were contemplating buying or selling.  However, we found that daily price movements for these ETFs (compared to mutual funds) are often a red herring (misleading) in terms of longer-term price trends for corporate high yield bonds.  Thus, we totally ignore ETFs now when making investment decisions.  However, we still may include some ETF charts in this blog for general information and educational purposes, as some readers may be interested.

Not Investment Advice | Important Disclaimer: 
The content in this article, including the identification and discussion of any specific security (e.g., bond fund), is NOT meant to be and should NOT be construed and/or used as investment advice. This article is for general information and educational purposes only. Please read the Disclaimers  for in their entirety. The U.S. Securities and Exchange Commission website has guidance on selecting an investment adviser.

Financial Disclosure:
The author/publisher owns shares of NHINX and other corporate high yield bond mutual funds. 

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