Credit Research 

U.S. Credit Focus 

Previously published in the U.S. Credit Alpha 17 February 2017 

17 February 2017 

Passive Aggression 

Jeffrey Meli  We examine the implications of the shift from active to passive management for 

+1 212 412 2127 liquidity in the investment grade and high yield markets. We estimate a modest 1.5-

jeff.meli@barclays.com 3.0% decline in bond turnover directly attributable to assets transitioning from active to 

BCI, US passive vehicles, but a much more significant indirect effect in high yield from 

institutional usage of ETFs. 

Eric Gross  Growing passive assets under management (AUM) in high yield reflect not only true +1 212 412 7997 

retail investors who own the funds as part of an investment strategy, but also eric.gross@barclays.com institutional investors who own them primarily for liquidity management. True retail BCI, US 

investors transitioning from active to passive are not a meaningful drag on high yield 

liquidity, but we believe that institutional ownership leads to a much larger decline in bond 

turnover. We estimate that this indirect effect reduced high yield bond turnover by 20% in 

2016, although it could have been as low as 10% or as high as 30%. This is significant 

relative to the approximately 140% turnover of high yield and could account for a 

substantial portion of the decline in turnover since the crisis. Investment grade is not 

affected by this indirect drag on liquidity, as institutional investors rarely use passive 

instruments to manage fund flows. 

 We see limited room for further declines in turnover from shifts into passive 

strategies. Passive penetration remains low in high yield and could increase, as 

evidenced by an increasing variety or products, including rates-hedged high yield ETFs, 

fallen angel ETFs, and target maturity ETFs. However, we do not believe that high yield 

passive penetration will exceed that in investment grade. Even in that scenario, the 

turnover implications are limited. 

 The size of secondary high yield ETF volumes is striking. The four largest high yield ETFs 

averaged secondary volumes of $1.6bn per day, on only $37bn of AUM. This compares 

with $12bn of daily volume in the high yield bond market (using TRACE data), which has a 

size of $1.3trn. Our analysis of retail flows suggests that only a small fraction of these flows 

can be attributed to retail. At the same time, the flows exceed the liquidity needs of fund 

managers by at least two-to-one, indicating that other institutions must be responsible for 

much of the secondary activity. We believe that some of this comes at the expense of 

secondary bond trading, but given what we know about the liquidity needs of the different 

owners of high yield, we believe the use of ETFs to substitute away from secondary bond 

trades is likely nearing saturation. 

FIGURE 1 

Secondary Volumes in High Yield ETFs Are Striking Relative to Their Size 

Ownership of HY Annual Secondary 

Market Turnover 

High Yield ETFs 3% 10.7x 

Other Owners of High Yield 97% 1.4x 

Source: Bloomberg, MarketAxess, Barclays Research 

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt 

research reports prepared for retail investors under U.S. FINRA Rule 2242. Barclays trades the securities covered in this report for its own account 

and on a discretionary basis on behalf of certain clients. Such trading interests may be contrary to the recommendations offered in this report. 

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES STARTING AFTER PAGE 11 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Barclays | Passive Aggression 

The Ascent of Passive Management 

The shift from active to passive management has been a long-simmering issue in financial 

markets. It has obvious implications for asset managers, who face heightened fee 

compression and competition for AUM as money flows into passive strategies. We believe it 

also has implications for the underlying financial markets, along two separate but related 

dimensions. First, as money shifts into passive strategies, the remaining active managers 

should face less competition, improving their chances of outperforming their benchmarks. If 

true, this would help establish an equilibrium split between the two investment styles. On 

the other hand, passive investing generally involves lower turnover (Figure 2), and an 

increasing share of passive therefore likely reduces available liquidity. If this second effect 

dominates, it would limit the ability of active managers to capture opportunities for 

outperformance; it could even make the shift into passive self-reinforcing. 

We quantify this second effect of the shift from active to passive in the corporate credit 

markets. There are different implications for investment grade than for high yield. We 

estimate that the direct effect of the transition from active to passive is a 2.8% drop in 

investment grade turnover, compared with 1.7% in high yield. Passive has had a larger 

effect on turnover in investment grade owing primarily to higher penetration of passive 

funds in that market. That said, the turnover implications are limited because retail has a 

small presence in the investment grade market and, more important, because passive 

instruments are not typically used by institutional funds1 to manage liquidity needs. 

FIGURE 2 

Average Portfolio Turnover for Top 20 Funds by AUM (%) 

0

20

40

60

80

100

120

140

160

180

200

US Govt Global EM US IG US Loans US HY US Equity US Munis

Active Passive

Source: Bloomberg 

In high yield, the use of passive vehicles by fund managers to manage flows leads to 

significant indirect effects on turnover. We estimate that this behavior reduced annual 

turnover by 20% in 2016. The liquidity implications of reduced turnover are likely more 

severe for high yield, where some securities are already difficult to trade, and institutional 

managers have taken steps to manage liquidity risk more actively. 

State of Passive Strategies across Asset Classes 

The flows into passive strategies have not been uniform across asset classes (Figure 3). In 

equities, US government, and US investment grade, passive strategies have a significant share 

of retail assets. While already over 40%, the passive share continues to increase in both equity 

and government funds. In loans and municipals, the passive share has remained small, likely 

1 We use the term “institutional” to distinguish between individuals and professional investment managers. Thus,

“institutional” includes not only pensions, endowments, and foundations, but also fund managers whose end users

may be retail investors. 

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Barclays | Passive Aggression 

for structural reasons. US high yield and emerging markets currently sit between those two 

extremes. They have seen some growth in passive strategies since the onset of the credit 

crisis, with the introduction of ETFs a likely catalyst. However, the shift has been small, and we 

may be overstating the extent of true retail passive investing, as institutional investors use 

ETFs to help manage cash needs. Clearly, in absolute terms, high yield has the potential for a 

substantial further shift into passive, given the gap to the high penetration asset classes 

mentioned above. 

FIGURE 3 

Share of Mutual Fund and ETF Assets in Passively Managed Vehicles 

0%

10%

20%

30%

40%

50%

'09 '10 '11 '12 '13 '14 '15 '16

US Govt US IG US HY US Loans

Global EM US Munis US Equity

43%

41%

35%

Grp 1

17%

12%

Grp 2

5%

3%

Grp 3

Note: Asset class breakdown based on EPFR classification. Source: EPFR 

The Effect of Passive on Investment Grade Turnover 

There are three components to this calculation: the ownership share of mutual funds in the 

investment grade market, the share of passive in the funds universe, and the difference in 

turnover between active and passive funds. 

1. Ownership of Mutual Funds 

We estimate the ownership share of each of the major holders of corporate bonds each year 

in our Outlook. The most recent estimate was a 16-18% share for mutual funds, a slight 

increase from previous years. This is computed by summing the investment grade 

corporate holdings of the investment grade funds database from EPFR. This category is 

really investment grade core funds, and many of those included own more than just 

corporates – the investment grade aggregate fund is a common benchmark, and it also 

includes Treasuries and mortgages. Therefore, we aggregate the underlying corporate 

holdings at the fund level to arrive at our estimate. 

2. Passive Share 

Next, we estimate the share of passive among this group, at 37%. The high passive 

penetration rate reflects the relatively mature nature of the passive industry in investment 

grade; the passive share has also been quite stable over the post-crisis period. Again, this 

analysis goes beyond the EPFR investment grade classification, which includes noncorporates, to specifically reflect the share of investment grade corporate bonds held in 

passive vehicles. We arrive at this estimate using the active or passive categorization at the 

fund level and then aggregate up the corporate holdings for that fund.2 

2 In both investment grade and high yield, we identified a small group of funds that are categorized as active, but have 

management fees and turnover statistics that are more akin to passive. While the prospectuses for these funds 

confirm that they can exercise discretion similar to active managers, we believe the funds are effectively passive. As a 

result, we consider funds with management fees less than 30bp and turnover less than 40% as passive. 

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Barclays | Passive Aggression 

3. Turnover 

Finally, we compare turnover for active and passive funds. These statistics are reported at 

the fund level. As mentioned above, investment grade core funds often include more than 

just corporate bonds, and assets such as Treasuries would likely have higher turnover than 

corporate bonds. Since we cannot apportion turnover by security type, we estimate the 

corporate turnover by looking only at dedicated corporate funds.3 We then assume that the 

broader funds have turnover in their corporate positions similar to the dedicated funds.4 

In addition, the turnover rates reported are calculated as the percent of the portfolio that is 

replaced in a given year. For example, a fund that sells 50% of its bonds and replaces them 

through market purchases would report a turnover of 50%. However, the associated trading 

volume could be as high as 100% (it could be lower than 100% if some of the purchases were 

done through the primary market). Therefore, we need to gross up the reported turnover 

statistics to translate them into secondary volumes. We double the reported numbers, 

recognizing that this is likely biased slightly upward (although this, too, is likely mitigated by our 

focus on the difference between active and passive funds, which participate in the primary 

market to a similar extent). 

We estimate that active funds trade 112% of their AUM per year and passive funds trade 67%. 

In other words, a shift from active to passive reduces secondary volume by 45%. 

Effect of Passive on Turnover 

We estimate the total effect of passive management on volumes in investment grade 

corporate bonds as the product of ownership, passive penetration, and the difference in 

turnover (Figure 4). The result of 2.8% is relatively small for an asset class with 

approximately 70% annual turnover. This is despite the high level of passive penetration, 

which is balanced by the relatively low ownership of retail. 

FIGURE 4 

Estimating the Direct Effect of a Shift to Passive on Investment Grade Bond Turnover 

Source: EPFR, Bloomberg, Barclays Researcht 

Other Considerations 

It is possible that our retail category misses some passive vehicles – such as third-party 

money managed by institutional managers that is not in fund form. This would show up in 

our “other” category of ownership, which is roughly 20% of the market. Even if the majority 

of this category is third-party money (and assuming a similar split between active and 

passive), we would estimate the total effect of passive at around 5% in turnover terms. 

3 We classify investment grade core funds as corporate funds if their portfolios are at least 75% corporate, based on 

Bloomberg data. 

4 Many “Agg” funds are sub-managed by different teams by product type (ie, Treasuries, securitized, and corporates). 

17 February 2017 4 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Barclays | Passive Aggression 

While more meaningful, that is still a small effect relative to the size of the decline in 

investment grade turnover. 

The Effect of Passive on High Yield Turnover 

Our first pass at high yield is to run the same calculation: 

 Retail fund ownership, at approximately 35%, is higher than in investment grade. 

 The passive share of funds is 15% – smaller than investment grade and mostly in the 

form of ETFs. The vast majority of the growth in passive has come since the credit crisis. 

 The active-passive turnover difference is 32%. We estimate active turnover at 102% and 

passive turnover at 70%. 

We combine these in the same fashion as above in Figure 5. The result is only modestly 

higher than in investment grade, at 1.7%. The direct effect remains limited because the 

lower passive share more than offsets the higher degree of retail ownership. 

FIGURE 5 

Estimating the Direct Effect of a Shift to Passive on High Yield Bond Turnover 

Source: EPFR, Bloomberg, Barclays Research 

However, the effect of passive on high yield turnover is more complicated than this. We 

believe that a substantial portion of the assets reported as passive does not represent true 

retail passive investing, in contrast to investment grade. Instead, it represents institutional 

managers using passive vehicles, including ETFs, to manage their inflows and outflows. 

Managers trade ETFs to fund outflows or invest inflows, and it is likely that at least some of 

these flows replace trades in the secondary corporate bond market. 

In Using ETFs to Mitigate Fund Flows, we showed that inflows and outflows are not 

perfectly correlated across funds. On average, 54% of fund flows are “diversifiable,”

meaning that portfolio managers can reliably use ETFs instead of trading bonds to satisfy a 

significant share of their own fund flows. Indeed, an analysis of the magnitude of fund flows 

at the fund level suggests that approximately 25% of the outstanding float in high yield 

ETFs could be held by portfolio managers with daily liquidity needs. 

Several pieces of evidence support this view (alongside anecdotal evidence from money 

managers and ETF traders). The first is the high concentration of assets among passive high 

yield funds. The top three passive funds represent 68% of passive high yield assets, while 

the top three passive government and equity funds represent 39% and 16% of passive 

assets, respectively. All of the large passive funds in high yield are ETFs, which have the 

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Barclays | Passive Aggression 

benefit of trading in the secondary market. High concentration leads to larger secondary 

flows, which is useful for institutional managers trying to use ETFs to manage inflows and 

outflows. Without sufficient secondary trading, selling of shares is more likely to lead to 

share destruction, which relies on the liquidity of the underlying market. ETFs mitigate 

liquidity needs only to the extent that their secondary trading volumes are large relative to 

primary volumes (ie, share creation and redemption volumes). A large number of thinly 

traded ETFs would not be useful to institutional managers. Indeed, the largest four high 

yield ETFs have secondary volumes of 4-8x primary volumes. 

The second piece of evidence is price. The active-passive cost difference for high yield is 

much lower than for asset classes with significant passive penetration (Figure 6). In fact, it is 

larger only than loans, where the passive share is de minimis. One of the draws of passive 

for retail investors is lower fees, and we would expect cost savings to be a key selling point 

for funds targeted at those investors. Given the high concentration, there appears to be 

room for funds to compete for retail share with lower fees. In contrast, an institution looking 

to ETFs to help manage liquidity is unlikely to be interested in a new, lower cost fund that 

has less secondary liquidity. 

FIGURE 6 

Average Expense Ratio for Top 20 Funds by AUM (bp) 

-30%

-38%

-40%

-46%

-74% -77%

-86%

0

10

20

30

40

50

60

70

80

90

US Loans US HY US Munis Global EM US Govt US IG US Equity

Active Passive

Source: Bloomberg 

Finally, the largest high yield ETFs are benchmarked to either a liquid sub-index or a short 

duration sub-index, with very little style diversity. The close link to the benchmark is 

important for institutions looking to minimize tracking error, but less important for retailoriented funds, which we would expect to target specific segments of the market. Although 

there has been some recent movement on this front (more on this below), the largest funds 

are surprisingly similar. The only differentiation has been the few funds focused on shortduration assets, which is particularly telling, given that short-duration bonds are commonly 

used as cash substitutes by high yield portfolio managers with daily liquidity needs. 

Estimating the Indirect Effect on Turnover of Institutions Using ETFs 

The passive share of high yield fund AUM can therefore be thought of as comprising two 

different types of owners: retail investors that own ETFs as part of their investment strategy 

and institutions that use them primarily for liquidity management. Secondary flows from the 

first group are not replacing corporate bond trading – they are similar to gross flows for an 

open-end mutual fund, which are netted at NAV. Secondary flows from institutions, 

however, may be replacing trades in the underlying corporate bonds. 

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Barclays | Passive Aggression 

This is an important differentiation, because the overall flows for high yield ETFs are large 

relative to the size of the high yield market, despite the relatively small size of the funds. 

Daily TRACE volumes in high yield bonds averaged $12bn last year. Secondary trading in 

the four largest high yield ETFs, which represent only about 3% of total high yield assets, 

was $1.6bn daily in 2016. The contrast in turnover is striking: we estimate annual turnover 

of about 1.4x for high yield, while the ETF numbers imply annual turnover of 10.7x. 

Secondary ETF volumes are so significant that, if they were fully substituting away from 

secondary corporate activity, the implications for bond turnover would be substantial. 

Figure 7 divides total secondary ETF volume by the size of the high yield market to convert 

those volumes into a turnover-equivalent measure. 

FIGURE 7 

ETF Volumes Divided by High Yield Par Outstanding 

4%

2% 2% 4% 4% 4% 5% 7% 6%

10%

16%

19%

15%

17%

29%

0%

5%

10%

15%

20%

25%

30%

35%

40%

'07 '08 '09 '10 '11 '12 '13 '14 '15 '16

ETF Fund Flows Secondary ETF Volume

Note: ETF flows are subtracted from secondary ETF volumes. Source: Bloomberg 

In order to understand the size of the ETF volumes, we estimate the potential contribution 

from a few possible sources of activity. First, we estimate how much secondary volume 

could be coming from retail owners of ETFs. For the overall retail fund universe, average 

daily gross fund flows have been $731mn over the past 15 months. ETFs represent about 

9% of retail, which would indicate that ETF gross flows from that investor base would be at 

most $65mn, per day (assuming that retail directly owned 100% of the ETFs outstanding, 

which we know not to be the case). Even if retail owners were more likely to trade ETFs than 

buy or sell open fund vehicles – which sounds sensible given the intraday tradability of ETFs 

– we think it is unlikely that retail owners make up more than 10% of total secondary 

volumes in ETFs. 

That leaves institutional owners to make up the remainder of the secondary flows. We can 

estimate the possible trading from open-end mutual funds, starting with the gross flows 

statistic cited above. Even if retail fund managers exclusively used ETFs to manage flows, 

this activity would account for about 46% of secondary ETF volumes. This is surely an 

overestimate of those institutions’ activity, for two reasons. First, only about 54% of those 

flows are diversifiable, meaning that ETFs cannot reasonably be used to satisfy every inflow 

and outflow. Second, these managers do not exclusively use ETFs for liquidity management 

– they also use other portfolio products, such as CDX, and liquid bonds. Unless fund flow 

volatility picks up materially, we believe that any incremental liquidity effect of retail funds 

using ETFs would likely be small. 

Other institutions (eg, institutional asset management mandates, pensions, endowments, 

foundations, and hedge funds) must therefore be driving a significant share of secondary 

17 February 2017 7 
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Barclays | Passive Aggression 

ETF volume. Surveys have indeed shown5 that these institutions have consistently increased 

their use of fixed income ETFs in recent years. At least some of this activity likely comes at 

the expense of bond trading. Some is also likely from trading that is opportunistic, given the 

high liquidity of high yield ETFs, such that participants are taking shorter-term views on 

high yield that would not otherwise be implemented in bonds. Given the high daily ETF 

volumes and the limited proportion that could be assigned to investors with the most 

demand for liquidity, we believe the negative effect of passive management on high yield 

turnover is likely nearing saturation. 

Could Passive Have an Even Larger Effect in the Future? 

Although the indirect channel discussed above is responsible for most of the effects of 

passive strategies on turnover today, we believe there is relatively little room for it to grow. 

Institutional holdings are likely near saturation, based on our analysis of fund-level flow 

volatility – absent a change in the nature of fund flows. 

However, the direct channel could grow, given the small share of high yield passive 

investments. The implications for high yield liquidity could increase if the share of passive 

management becomes more akin to that of other high-penetration asset classes. There are 

signs of potential growth in retail-oriented passive, as evidenced by a growing variety of 

products, including rates-hedged high yield ETFs, fallen angel ETFs, and target maturity 

ETFs, which are clearly intended to be used as investment strategies rather than liquidity 

vehicles. Sub-indices can be challenging to track because of low liquidity, but funds can 

alleviate this problem by judiciously choosing sub-indices with lower turnover, such as 

specific maturities or fallen angels. 

To determine the likelihood of meaningful gains in passive share, we compare high yield 

with other asset classes along two dimensions that we believe contribute to the 

attractiveness of passive strategies: 

 The potential for active alpha generation. The more sources of systematic and 

idiosyncratic risk an asset class is exposed to, the more avenues an active manager has 

to outperform. We stack up high yield versus the high-penetration asset classes. 

 The existence of viable, investable passive instruments with limited tracking error and 

low transaction costs. We assess the potential attractiveness of passive high yield 

investments to retail investors. 

Potential Sources of Alpha 

The promise of outperforming a benchmark is increasingly plausible when active managers 

have many demonstrable paths to doing so. However, asset classes are not created equally 

with respect to alpha opportunities. Asset classes have different sources of systemic or 

idiosyncratic risk, and those with more sources of risk are more suitable for active 

management. 

We assess the potential for active outperformance, incorporating dimensions of risk and 

liquidity and market structure (Figure 8). We score market structure and liquidity on a scale 

of one to five, with higher numbers representing higher liquidity and ease of settlement. A 

higher score in this section makes a passive instrument easier to create. We score potential 

sources of alpha, also from one to five. Higher scores in these areas improve the potential 

for alpha in that asset class, increasing the “active score.” We then compute an overall ratio 

as the total score for alpha divided by the total score for market structure and liquidity. 

5 See Institutional Investment in ETFs: Versatility Fuels Growth, Greenwich Associates Q1 2016. 

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Barclays | Passive Aggression 

This approach is admittedly arbitrary, but it is telling that the asset classes with the highest 

scores have thus far had lower passive penetration, and vice versa, suggesting that market 

structure, liquidity, and opportunities for alpha are key determinants in the tug of war 

between active and passive strategies. For example, the US government asset class has a 

low active score, with very high liquidity and few sources of alpha, making it an ideal target 

for passive management.6 US equities have a few more sources of alpha, but they are also 

quite liquid, and some of the most commonly used equity indices have a limited number of 

securities relative to fixed income indices. At the other extreme, US loans and municipals 

have high active scores, with both structural impediments to passive management and 

significant sources of potential alpha. 

FIGURE 8 

Asset Class Scores for Liquidity and Sources of Alpha (1 = Low, 5 = High) 

US 

Govt 

US 

Equities US IG US HY 

Global 

EM 

US 

Loans 

US 

Munis 

Market Structure and Liquidity 

Liquidity 5 4 3 3 2 3 1 

East of Settlement 5 5 5 5 5 2 5 

Exchange/OTC OTC Exch OTC OTC OTC OTC OTC 

Systematic Alpha 

Market Risk 1 5 2 4 5 4 2 

Rates/Term Risk 5 1 4 2 4 1 5 

New Issue 1 2 4 4 4 4 3 

Idiosyncratic Alpha 

Dispersion of Security Returns 1 5 3 5 5 4 2 

Number of Securities 1 3 4 3 3 2 5 

Number of Issuers 1 3 2 2 2 2 5 

Number of Sectors 1 3 3 3 5 3 5 

Security Features1 1 1 3 5 3 5 5 

Active Score 1.2 2.6 3.1 3.5 4.4 5.0 5.3 

Note: Security features include collateral, seniority, covenants, and embedded options. Source: Barclays Research 

The active score for US high yield is in the middle; it appears somewhat more amenable to 

active management than equities and investment grade credit, but less so than other asset 

classes with a low passive share. This speaks to the possibility of continued gains in passive 

– certainly, this scenario does not appear to be precluded by the nature of the asset class, 

despite the high level of alpha potential. 

The Viability of Passive High Yield 

In liquid asset classes, full index replication is a viable passive strategy. However, there are 

enough small issues in high yield with irregular trading that implementing this strategy is 

not practical. Instead, passive high yield funds are benchmarked against liquid sub-indices, 

such as the Bloomberg Barclays US HY Very Liquid Index (VLI). These sub-indices are 

almost liquid enough to replicate, but the funds still utilize sampling: US high yield ETFs 

typically own about 90% of the members of their liquid sub-index benchmarks. This level of 

sampling limits tracking error while allowing passive managers to avoid incurring excessive 

transaction costs from being forced to trade the least liquid securities. 

6 The gap to the other asset classes is likely overstated somewhat, as government funds likely have sources of alpha 

(eg, though securities lending) that we do not account for. 

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Barclays | Passive Aggression 

The potential downside of using a sub-index is if the characteristics of the sub-index differ 

in some material way from the broader index, such that the passive funds are structurally 

set up to underperform active funds that can invest in the full universe. While this was true 

to a certain extent at one time, changes to the way the VLI and similar indices are 

constructed have limited the differences (Figure 9). 

FIGURE 9 

Comparison of US High Yield and US HY Very Liquid Indices 

Yield (%) OAS (bp) Duration Average Liquidity Cost 

(yrs) Rating Score (%) 

US High Yield Index 5.75 380 4.02 B1/B2 1.1 

US HY Very Liquid Index (VLI) 5.65 363 4.01 B1/B2 0.9 

Source: Bloomberg 

We do not believe that the VLI is likely to systematically underperform or outperform the 

overall high yield market, and the distribution of liquidity in the underlying bonds is 

sufficient for managers to track the performance of the sub-index closely enough. As a 

result, we do not believe that viability poses an impediment to gains in passive share. 

US high yield does have characteristics that make it amenable to passive management. 

Furthermore, a liquid sub-index can be a viable proxy for the overall market, giving passive 

managers a solid foothold. While the asset class has good potential sources of alpha, its 

“active score” is only marginally better than that of investment grade, where 37% of funds

are passively managed, compared with 15% in high yield, apparently leaving considerable 

room for passive strategies to grow. 

More recent products stand out because of their much lower costs and focus on a broadmarket index rather than a liquid sub-index. Those choices imply that these products are 

meant for cost-sensitive retail investors rather than liquidity-sensitive institutional 

managers. Lower costs are indeed a key feature for retail investors. Morningstar data show 

that funds in the lowest fee quintile have attracted the lion’s share of inflows for a long time

and that the other 80% of funds have, in aggregate, experienced net outflows over the past 

decade (Figure 10). This trend has driven continued fee compression across the entire fund 

landscape. The average management fee for active funds in 2000 was 101bp, according to 

Morningstar; that average had dropped to 78bp by the end of 2015. Even passive funds are 

responding to the demand for lower costs, with the average fee dropping from 26bp to 

18bp over the same period (Figure 11). 

FIGURE 10 FIGURE 11 

Net Annual Fund Flows by Fee Quintile ($bn) Asset-Weighted Expense Ratios (bp) 

-300

-200

-100

0

100

200

300

400

500

600

'02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15

Quintile 1 (Passive) Quintile 1 (Active) Q2-Q5 (All)

0

20

40

60

80

100

120

'90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14

Passive Active All

Note: Data as of December 31, 2015. Source: Morningstar Source: Morningstar 

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Barclays | Passive Aggression 

The Future of Passive High Yield 

We believe not only that passive is viable in high yield, but also that its penetration rate is 

likely to increase. Assuming that half of the current 15% passive share actually represents 

institutions using the ETFs for their liquidity and simplicity, the true retail passive share of 

high yield could increase about 29% before it matches investment grade, where passive is 

almost entirely a true retail product; that scenario would put the passive share of high yield 

at about 45%. We see that as a cap, given that high yield passive should be no more viable 

than investment grade passive. However, the associated decline in high yield turnover under 

even a 45% passive penetration rate is only an additional 3.6%. As shown above, most of 

the adverse effects of passive management on high yield liquidity do not come from true 

retail substitution, but rather from institutional usage. 

Thus, understanding the growth in institutional usage is the key to determining potential 

future liquidity impairment. Retail funds already use ETFs for liquidity management, and we 

believe that barring a meaningful change in fund flow volatility, that channel may be 

saturated. That said, institutions such as pensions and endowments could certainly 

continue to increase their usage, some of which would substitute for bond trading. 

Importantly, this continued shift could lead to a self-reinforcing decline in high yield 

liquidity. More passive strategies should theoretically make it easier for active managers to 

outperform as competition declines. However, liquidity also deteriorates with more passive 

investment, making it more difficult to convert alpha opportunities into actual 

outperformance. If the latter effect dominates, the shift to passive could become selfreinforcing. We believe active investors will be grappling with this trade-off for the 

foreseeable future, particularly in years of low idiosyncratic volatility. 

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Analyst Certification 

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