1. Limited supply of issues could impact holdings. Weakening credits are usually easier to buy.
2. In a slowing economy downgrades usually increase percentage of “distressed” credit ratings in index.
3. Index may have unwanted exposure. Autos, today, 2007; Telecom in 1999.
4. In 1989 and 1990 the Barclays HY Index principal value fell about 25%.
5. Market makers may bid for ETF shares well below NAV and offer well above
6. NAV ( see Wall Street Journal 3/17/07 noted 7.8% difference in ETF bid and NAV of shares for a large fund).

Investing in a passive benchmark as an alternative to active management could be more risky. Unlike the equity indexes, such as the S&P 500, where all securities are readily available for purchase and sale, this is does not hold true for the high yield market. The Barclays High Yield Index (12/31/06) has 1616 securities with an average issue size of about $406,000,000. This is “float” per issue is miniscule compared to that of S&P 500 stocks. So, replicating the index is problematic, because there is a very limited supply of the represented securities (prompting high tracking error concerns).

Another important issue for most indexes is that they are market capitalization weighted. This fosters the concept of the “bums” problem. That is the biggest issuers (and industry groups) are larger components of the index. The current composition of the LBHY emphasizes this point. Currently (12/31/2006) the two largest “bums” in the high yield market are Ford and GM with a market share of 6.2% and 5.9% respectively. Also, the automotive sector is 13.9% of the index. So, managing to the index forces exposure to potentially undesirable or deteriorating credits and sectors. These automotive industry “fallen angels” may have further to fall.

Back in 1999 the telecom sector grew through investor infatuation to 21% of the index. Just three years later through bankruptcies it shrank to just 10% of the index. As of 12/31/2006 it is just 7% of the Barclays High-Yield Index.

Another consideration is the increase in credit downgrades when the credit cycle begins to deteriorate. As the number of lower quality issues grows and lower ratings become a larger portion of the index the fund increases its exposure to weaker credits.

Currently (12/31/06) CCC and lower rated bonds represent 16.4% of the index. Full cycle total return performance has been poor relative to the BB and B rated “upper tier.”

The High-Yield market is quite different due to its exposure to credit and industry cycles. Companies come and go, and industry sectors grow and shrink over several years. We feel this dynamic favors active management for more conservative investors.