Understanding Fixed Income ETFs ( Exchange Traded Funds )

Please note that the following piece is for information purposes only and is not intended to constitute any investment advice, recommendation or solicitation. This is not an offer to sell any product. Muzinich & Co. is not involved in the management or distribution s. This thought piece was written after a review of the offering documents and prospectuses s provided by other advisors/providers in the industry as well as discussions with traders whose work involves ETFs. Understanding Fixed Income ETFs ( Exchange Traded Funds ) ETFs have gained in popularity over the last several years as investors seek exposure to a wide variety of asset classes. While ETFs have typically been associated with listed equity markets, high yield ETFs have recently experienced rapid growth as the asset class has attracted investors looking for yield in today s low yield environment. The purpose of this paper is to explain high yield ETFs, specifically addressing how they function, some of their subtleties and general advantages and disadvantages. ETF Background ETFs are securities that track a pre defined index or a commodity, but trade like a stock on an exchange. Since ETFs are index based, fundamental credit analysis is not conducted on the names in a fund and portfolios are not constructed with a view on the economic environment and outlook. ETFs are priced like a stock that is continuously during market hours, while a mutual fund or UCITS is priced once a day at market close. ETFs allow even a small investor buying a single share to gain exposure to an entire asset class. As a result, ETFs are extremely popular with retail investors. ETFs are also employed by sophisticated investors looking to hedge their books or exploit arbitrage opportunities. High yield ETFs have gained in popularity as 1) they allow for intraday trading with no redemption fees or minimum holding periods; 2) they are considered a tactical tool for the buy and sell trader; and 3) the high yield asset class has attracted significant investor interest due to higher relative yields and strong corporate fundamentals. The first ETF, which we will refer to as the Broad Equity Market ETF, began trading in January 1993 providing investors exposure to the S&P 500. It remains one of the most actively traded ETFs and also one of the largest, at $103 billion. The first high yield corporate ETFs were launched in 2007. The chart below highlights the two largest passively managed high yield ETFs, which we will refer to as High Yield ETF 1 and High Yield ETF 2. HY ETF 1 is currently $10.5 bn in assets and HY ETF 2 is $14.2 billion. Both of these ETFs have experienced strong growth largely as a result of increased investor interest in high yield. 1

350 Growth s 180 300 160 250 200 HY ETF 1 HY ETF 2 140 120 100 150 100 80 60 40 50 20 0 0 11/28/2007 11/28/2008 11/28/2009 11/28/2010 11/28/2011 Source: Bloomberg. Key Highlights of Corporate Bonds Before we discuss how fixed income ETFs function, it is helpful to provide a quick overview of the corporate bond market. Corporate bonds are issued by a wide variety of companies to finance operations or acquisitions. Corporate bonds, just like all other segments of the fixed income market, are issued and traded in an over the counter ( OTC ) market. An OTC market is a decentralized market of securities not listed on an exchange where market participants trade over the telephone, facsimile or electronic network instead of a trading floor. There is no central exchange and trading is conducted via a network of dealers. The corporate bond market is less liquid than the treasury, foreign exchange or equity markets. This is a function of several factors such as: 1) the smaller size of the corporate bond market; 2) the variety of bond issues an investor can choose from in a single company; and 3) regulatory issues related to registration with the SEC. The over the counter and less liquid nature of the corporate bond market, coupled with intra day exchange trading of an ETF, leads to a mismatch between the pricing of securities underlying the net asset value ( NAV ) of a fixed income ETF and the actual trading prices of the fixed income ETF. This mismatch leads to challenges in the way these ETFs are managed and detracts from their performance as market participants price in premiums and discounts to NAV on an intra day basis. These nuances will be discussed later in this paper. How Fixed Income ETFs Function: Rules Based System Outsourced to Index Providers ETFs track the performance of a pre determined underlying index by replicating the holdings of that index over time. There are essentially three main players associated with a high yield ETF, each with a specific function: the creation of the index, the creation of the ETF and the creation and destruction of shares in the ETF. The roles are detailed below: 2

Index Provider: The Index Provider defines the investible universe or index based on specific rules. One example of a high yield index is the Barclays Capital High Yield Very Liquid Index. It is based on a predetermined set of rules. A subset of these rules is listed below: Outstanding face value of a bond must be greater than or equal to $600 million Each issue must have been issued within the past three years, and include only the largest issue from each issuer Bonds must have an expected remaining life of at least 1 year Bonds must be corporate credit Bonds must be denominated in US dollars Index must be rebalanced on the last business day of the month Bonds must be high yield. If three ratings, the middle rating is used after dropping the highest and lowest. If two ratings, the lowest is used Source: Barclays Capital High Yield Very Liquid Index Fund Manager: The Fund Manager is responsible for providing a daily list to market makers (defined below) of credits for purchase or sale. The list is created by the Fund Manager by comparing the index to the ETF holdings and determining which names need to be bought or sold to reduce the ETF s tracking error compared to the index. The daily list is a subset of names of the index. The manager of HY ETF 2 s daily list typically consists of 40 names while the manager of HY ETF 1 s daily list typically consists of 50 names. The ETF generally holds fewer than the total number of securities in the Index. Thus, on a daily basis the high yield ETF Fund Manager does not replicate the index based on fund flows; rather the Fund Manager only approximates the index. This is a major difference compared to listed equity ETFs and a source of potential tracking error. Authorized Participants, Market Maker, and Underwriter: These are three different terms for the same function. Authorized Participants aggregate ETF share purchases and sales, trade underlying bonds in amounts corresponding to purchases and sales, and transfer bonds to the Fund Manager for daily share creation or destruction. When demand exceeds supply, shares are created and when supply exceeds demand they are destroyed. Using the list provided by the Fund Manager, Authorized Participants buy or sell names to approximate the index. HY ETF 2 s manager requires Authorized Participants to trade all 40 names on the daily list, while HY ETF 1 s manager only requires 7 names out of the 50 on the list. It is important to note that Authorized Participants don t provide cash to the Fund Manager, only securities are acceptable. As a result, shares are created or destroyed on a daily basis in exchange of bonds instead of simply deploying cash to the Fund Manager. 3

The schematics below details how the different players work together in managing and creation shares: How the End Client Receives Their ETF Upon Purchase End Client (Retail Investor) Cash Brokerage Firm Cash Exchange Cash Authorized Participant (Aggregates Purchases) Authorized Participants Purchase Methodology Below Authorized Participant trades bonds on behalf of the ETF to create or destroy shares Provide List as well as ETF units Provide Securities Fund Manager provides list of credits for purchase or sale acts as custodian and holds all securities record keeping creates or destroy shares in exchange for bonds Brokerage Firm End Client Creation or Destruction When units are CREATED underlying holdings (bonds) of the ETF need to be purchased ETF When units are DESTROYED underlying holdings (bonds) of the ETF need to be sold 4

Daily Trading Pre Market Open Market Hours 4 pm Authorized Participants receive overnight a list of issuers that they should transact in during market hours Watch flows throughout the day Aggregate ETF trade orders Transact in market based on demand ETF stock trading stops Limitations/Nuances of Fixed Income ETFs High yield ETFs are subject to several nuances, many of which can be considered a limitation. Exact Replication of Index Is Nearly Impossible and Attempts to Replicate Index Lead to Higher Transaction Costs The ETF Fund Manager determines the list of credits that should be bought and/or sold in the ETF fund with the goal of replicating the index as closely as possible. Depending on supply and demand dynamics on a particular day, Underwriters might find it difficult or costly to purchase credits on this list. This is particularly true in periods of market stress, when Underwriters are forced to transact in specific names regardless of bid offer spreads. These large transaction costs are absorbed by the fund. The Underwriter s main objective is not to reduce transaction costs, but rather to replicate the index as closely as possible according to the daily list provided by the Fund Manager. The table at left highlights the top 10 index weightings while the chart at right highlights top 10 ETF weightings. Although Fund Managers and Underwriters work to make these two lists exactly the same, it is often difficult to achieve this because of the over the counter and less liquid nature of the bond market. Source: Bloomberg & Barclays Capital High Yield Very Liquid Index. As of 5.31.2012 5

Premium/Discount Significantly Higher for Bond ETFs than for Equity ETFs High yield ETFs are often priced at a significant premium or discount to the actual NAV of the fund. This large premium or discount is a function of the mismatch between the way in which the ETF trades (as a stock throughout the day), and the way in which the Underwriters attempt to replicate the index. The high yield ETF Underwriter prices in a discount or premium to the ETF trading price depending on the value of the underlying bond portfolio and the level supply and demand in the secondary market. These ETF price deviations are built in so that Underwriters do not lose money when they actually begin to transact in the underlying bond basket. Is essence, premiums/discounts are a means by which Underwriters reduce their intra day market risk, since there can be a timing mismatch between when ETF shares are bought and sold and when underlying bonds are traded. The premium range of HY ETF 2 is 729 bps compared to 29 bps for the Broad Equity Market ETF over the past year. The current average price of HY ETF 2 takes into account a 56 bps premium compared to 0.04 bps for the Broad Equity Market ETF. The chart below highlights the wide swings in premium and discounts for HY ETF 2 compared to the stability of the equity ETF. In short, high yield ETF investors pay significantly more to gain exposure to the market versus their equity counterparts. 4 Premium Discount HY ETF 2 Vs. Broad Equity Market ETF 3 2 1 0 1 2 3 4 5 HY ETF 2 Broad Equity Market ETF May 31, 2011 to May 31, 2012. Source: Bloomberg. ETF Share Count Volatility Affects Bond Price Volatility in high yield ETFs directly affects bond prices as ETF funds are large buyers in the high yield market and can impact bond prices through their index oriented trading. When a high yield bond ETF share is redeemed, the Authorized Participant must sell bonds, even if the manager believes the price of a bond will ultimately rise. The inverse is true as well, when a high yield ETF s share count rises, the manager must buy bonds, based only on what the index holds. In contrast, an active manager conducts fundamental credit research and buys and sells based on fundamentals, relative value, and technicals. 6

ETF Funds Typically Exhibit Significantly Higher Volatility than Actively Managed Funds High yield ETFs exhibit significantly higher volatility compared to actively managed funds for several reasons. First, ETF Underwriters are forced to buy and sell regardless of bond prices since the Funds don t hold cash. There is some anecdotal evidence that high yield and hedge fund managers move in advance Underwriters adding to volatility making it even more costly for ETFs to build positions. Second, ETFs include a market weight allocation to CCC rated credits and all market sectors. Some of the CCC rated bonds in ETF portfolios are likely to default, leading to losses as the name drops out of the index and is sold by ETFs. Unlike an actively managed fund, ETF underwriters do not underweight/overweight sectors based on a macro view. As such, ETF investors will have full exposure to troubled sectors in periods of market stress. Third, the daily premiums and discounts priced into the index which were discussed earlier also add to volatility. ETF Price Volatility Offers an Arbitrage Opportunity High yield ETF Managers attempt to replicate the index throughout the month. Due to the OTC nature and lower liquidity of the bond market, it is difficult for ETFs to get the allocations to a credit that they desire on a daily basis. The mis match is remedied at month end, when the Underwriters work to rebalance the portfolio in order to more closely track the index. This month end re balancing presents other high yield market participants with an arbitrage opportunity. Index weightings and ETF Fund weightings are publicly available information provided on a daily basis. ETF weightings will need to move in line with index weightings by month end. As such, a high yield investor that is aware of this will go long the bond that the index is overweight versus the ETF fund positions. The ETF underwriter will have to buy this bond, regardless of price given their mandate to replicate the index. By buying these bonds prior to month end, an active high yield investor can benefit from capital appreciation. Performance of High Yield ETFs vs. Actively Managed Funds Passively managed high yield funds have underperformed an actively managed U.S. high yield fund as represented by the Muzinich U.S. high yield composite*, with significantly higher volatility. The underperformance s stems from the lack of fundamental credit research and the necessity to replicate an index irrespective of cost or relative value, as well as the premiums and discounts that are built in as a cost to the investor. The index has a greater exposure to CCCs as well as to credits that default and leave the index. The chart below highlights the superior returns and lower volatility that an actively managed fund can generate compared to an ETF. Return and volatility statistics are based on monthly performance figures. January 2008** to May 31, 2012 HY ETF 1 HY ETF 2 Muzinich US HY Composite (Net) Muzinich US HY Composite (Gross) Annualized Return 5.31% 5.53% 7.20% 7.78% Annualized Vol 18.82% 16.88% 10.79% 10.78% Source: Bloomberg 7

The chart below highlights year to date performance of the Muzinich U.S. High Yield Strategy and HY ETF 1. In May, the market exhibited softness. While the Muzinich U.S. High Yield strategy modestly declined, HY ETF 1 experienced a more dramatic drop off of 3.5%. 106 YTD Performance 105 104 103 102 101 100 Muzinich U.S. High Yield Strategy HY ETF 1 99 98 97 96 1/3/2012 2/3/2012 3/3/2012 4/3/2012 5/3/2012 Source: Bloomberg. Conclusion We believe high yield ETFs represent a tactical tool for investors wishing to trade market extremes or hedge their high yield exposure via a short on the ETF. ETFs prove valuable when used effectively for these reasons given their higher volatility. The table below summarizes the benefits and disadvantages of investing in high yield ETFs versus actively managed high yield funds: Factor HY ETFs Active Funds Management Style Passively managed downside risk can be greater in passively managed funds as credits are added to portfolio with no Actively managed risk is managed through bottomup fundamental credit analysis and active portfolio management consideration of fundamentals. Higher exposure to defaults Trading Intra day at premium or discount Priced after market close at NAV Fees Low Varies by Manager Diversification Significant diversification particularly useful for smaller investors unable to build diversified portfolios. Exposure to wider cross section of credits that increases risk of individual defaults High transactions costs associated with effort to replicate the index. Significant diversification, however, lower individual name count than index. Active funds purposely avoid certain credits and sectors. Transaction costs Lower transaction costs as traders seek best price Volatility Higher Lower and actively managed 8

We also believe that total return oriented, buy and hold investors are better served investing in an actively managed fund given relative performance, lower default loss and lower volatility. The high yield asset class rewards investors who maintain an exposure to the strategy over the long term due to the power of compounding a steady income stream. In a bull market, high yield will benefit from some capital appreciation, provided bonds are bought at a discount to par. In a bear market, high yield s returns are continuously bolstered by the coupon payment. As long as the active manager is able to avoid defaults through fundamental research, investors will be partially shielded from market volatility by high yield s strong coupon component. June 2012 Disclaimer *The Composite includes all fee paying discretionary U.S. high yield accounts managed with similar objectives for at least a full quarter. Composite performance reflects reinvestment of income and dividends and is based on an asset weighted average of the time weighted returns of each account in the Composite. Performance is expressed in U.S. dollars. The U.S. Composite creation and inception date is January 1, 1991. As of May 31, 2012, the U.S. High Yield Composite consisted of seven high yield accounts with assets totaling approximately $1.9 billion. The benchmark used is the JUC4, the Bank of America Merrill Lynch U.S. High Yield BB/B Cash Pay Constrained Index. Net Annualized Returns (through May 31, 2012) 1 year 3 year 5 year Muzinich U.S. HY Composite (net) 3.99% 13.12% 5.98% BofA ML US HY BB/B Constrained Index (JUC4) 4.13% 14.54% 6.88% Muzinich & Co. comprises all assets managed by Muzinich & Co., Inc. and its subsidiaries. Muzinich & Co., Inc. is an SEC registered Investment Adviser. Muzinich & Co. claims compliance with the Global Investment performance Standards (GIPS ). Muzinich has not been independently verified. The Muzinich GIPS Compliant Presentation for this composite can be found at: http://www.muzinich.com/gips/composite_01_us_hy_gips_compliant_presentation_june_2012.pdf Muzinich & Co., Ltd. is registered and authorized by the FSA. This material is intended for Professional Clients under the Markets in Financial Instruments Directive, where relevant. This is not an offer to sell any product. Past returns do not offer guarantees for future performance. Economic conditions can have a material effect on results and investments can lose money as well as gain. ** January 2008 represents the first full month of performance data for HY ETF 1. As such, 12/31/2007 became the start date as each of the HY ETF 2, HY ETF 1, and Muzinich U.S. High Yield Composite had track records by that time that included a complete first month. 9