How a High-Yield ETF Beat Its Benchmark

NEW YORK ( TheStreet) -- As an actively managed exchange-traded fund, Peritus High Yield ( HYLD) aims to outdo index funds that passively track benchmarks.

Lately Peritus has been succeeding. The high-yield fund returned 12.9% this year, finishing more than one percentage point ahead of such passive competitors as iShares iBoxx $ High Yield Corporate ( HYG) and SPDR Barclays Capital High Yield Bond ( JNK), according to Morningstar.

Can the active fund deliver compelling long-term returns? Perhaps. The year-old fund has an intriguing contrarian strategy that has prospered in the strong market of the past year. But the approach does take risks that could prove costly the next time investors flee low-quality bonds.

The Peritus fund focuses exclusively on high-yield bonds, which are rated below-investment grade. To outdo the benchmarks, Peritus portfolio manager Tim Gramatovich favors bonds that the index funds pass over. Those include many small issues. He says that the SPDR fund -- which has more than $12 billion in assets -- only considers issues of at least $600 million.

Portfolio managers of big funds figure that a smaller bond can be cumbersome to trade and have little impact on their total returns, Gramatovich says. But with $176 million in assets, Peritus can nimbly trade bonds of all sizes. "We shop in areas of the market that many other funds ignore," says Gramatovich.

Because big funds avoid them, many of the small bonds sell at discounts. That suits Gramatovich, who is a die-hard value investor. The bonds in his portfolio trade for 95 cents on the dollar. Since high-yield bonds have rallied recently, the bonds in the index now sell for $1.03.

The bonds that Gramatovich favors yield 8% or more. That is a fatter payout than many large bonds command. The Peritus fund yields 8.4%, while its passive competitors yield around 6.8%.

Although the active ETF may come with higher yields, it also has lower credit quality. The portfolio has 10% of its assets in bonds rated double-B, the highest rating in the below-investment grade universe. About 75% of assets are in bonds rated B. In contrast, the SPDR fund has 37% of assets in double-B and only 48% in B.

The lower quality bonds could sag in a downturn. But Gramatovich argues that his holdings could survive recessions and continue making interest payments. He says that the ratings agencies often give small bonds lower grades than they deserve.

A favorite holding is an issue from EnergySolutions ( ES), which disposes of radioactive wastes for government and commercial customers. The bonds yield more than 10% and trade in the mid $90s. The bonds sank recently after the company reported disappointing earnings. But Gramatovich argues that the company will rebound because it provides a vital service.

Since the beginning of 2011, assets in high-yield ETFs have grown from $13 billion to more than $28 billion. All that cash has helped to push up bond prices. Now many analysts worry that high-yield bonds have become too expensive.

Gramatovich agrees that certain issues are rich. He says that some of the double-B-rated bonds favored by the index funds only yield 4%. That is too low of a payout to compensate for the risk of default. But he argues that his fund's unloved issues are still bargains. At a time when five-year Treasuries yield 0.62%, bonds that can yield 8% are worth holding.

Gramatovich says that the current environment is ideal for his bonds. With the economy growing slowly, few companies are defaulting. At the same time, the outlook is so uncertain that corporate executives are hording cash and avoiding risky investments. That provides security for bond holders.

"We don't need a great economy," says Gramatovich. "We like exactly the environment that we have."

At the time of publication, Luxenberg had no positions in securities mentioned.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.