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ETFs vs. Mutual Funds: High-Yield Debt

For long-term investors, mutual funds that invest in high-yield debt outperform comparable ETFs.
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) -- Exchange-traded funds are grabbing increasing attention from investors due to their low cost, transparency and unique offerings, but that doesn't mean mutual funds are out of the game.

On the contrary, when it comes to high-yield bonds, mutual funds are besting their ETF competitors in total return.

More than $1 billion combined flowed into the two largest high-yield ETFs in March: the

iShares iBoxx High Yield Corporate Bond


and the

SPDR Barclays High Yield Bond


. This impressive inflow indicates that investors are not only seeking out high yields, but also that retail investors are becoming more confident about the U.S. and global economic recovery.

HYG, the older of the two ETF instruments, has been able to accumulate more than $5 billion in assets since launching in the first quarter of 2007. The fund has a 0.50% expense ratio, an 8.1% yield and an index consisting of 300 individual constituents.

HYG's top holdings include the debt of

Texas Competitive Electric





Sprint Nextel


. Due to the depth of the fund's underlying index, no single holding steers its performance, and HYG's top 10 holdings account for only 10% of its portfolio.

JNK, which hit the ETF scene at the close of 2007, has attempted to steal some market share with its lower 0.40% expense ratio and an 8.3% yield. Although JNK is in second place, it has still been able to amass a respectable $4.5 billion of its own.

Compared with HYG, JNK's index is more concentrated, with the top 10 holdings accounting for nearly one-fifth of the fund's total index. Top holdings include debt securities issued from





(GJM), and




HYG and JNK, however, are not the only tools that allow investors access to high-yield debt. The

Federated High-Income Bond Fund



Fidelity High Income Fund


are two options worth considering.

FHIIX and SPHIX, like their ETF cousins, track a select basket of low-grade corporate debt. However, while HYG and JNK are designed as passive products, the mutual fund offerings take an active approach to the industry, relying on the investing savvy of their respective managers. This strategy allows FHIIX and SPHIX to alter holdings to better track the market. Unfortunately for investors, it also leads to higher expense ratios. SPHIX and FHIIX charge investors 0.77% and 1.23%, respectively, in addition to short-term fees of 1% and 2%, respectively, for any shares held less than 90 days. FHIIX also has a 4.5% front end load.

The higher fees explain why these two mutual funds pay out lower yields than their ETF competitors. SPHIX yields 7.0% while FHIIX yields 7.2%.

Although their high costs and lower yield may seem like shortcomings, when it comes to total returns, the mutual funds have maintained a commanding lead over the ETFs. During the most recent two-year period, JNK and HYG have recorded total returns of 12.8% and 11.1%, respectively. FHIIX and SPHIX, on the other hand, have gained 18.9% and 20.6%, respectively. Having active management has paid off.

Year to date, JNK and HYG are up 6.0% and 4.0%, respectively, while FHIIX and SPHIX are up 5.2% and 5.6%, respectively.

For investors looking to trade in and out of the market, ETFs will continue to be the best option. HYG and JNK are more attractive for short-term trades due to their transparent nature, their ability to trade throughout the day, and the lack of short-term trading fees. Volatility is also a plus for traders. At one point the ETFs were down 4% or more this year, compared to less than 2% for the mutual funds.

For long-term investors, mutual funds are the better choice due to their total return outperformance.

Over the past year I have used HYG and FHIIX for my wealth management clients. In addition to income, the potential for price appreciation has made the sector attractive.

-- Written by Don Dion in Williamstown, Mass.

At the time of publication, Dion owned the iShares iBoxx High Yield Corporate Bond and the Federated High-Income Bond Fund



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Don Dion is president and founder of

Dion Money Management

, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years' experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.

Dion also is publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers.