Bond ETFs provide accessibility to the vast bond market.
They are gaining attention because of discrepancies between what investors pay for the ETF and their net asset value.
ETFs are good for capturing the returns of a category instead of simply obtaining a single holding, but it's important for investors to understand their pricing and recognize potential pitfalls.
Investors are always searching for ways to invest more effectively. Whether they're looking to minimize fees, maximize returns, or be more efficient—the industry adapts by creating investing tools and instruments. Mutual funds were all the rage with investors in the 1980s—now they're sharing the spotlight with another investing tool, the exchange traded fund (ETF).
First created in the early ‘90s, an ETF is a product designed to track the performance of a particular index. An ETF is a basket of securities that trades on an exchange throughout the day like an individual stock. There are over 700 stock ETFs in the US alone, and the list seems to grow daily—commodities, currencies, and other assets even have their own ETFs or ETNs (Exchange Trade Notes—a similar vehicle). Like many investing tools, ETFs can be a useful instrument for investors, but can also be misused and misunderstood. They are not a panacea.
Bond ETFs are great examples, first launched in 2002 to tap the vast bond market. They're increasingly popular—from only a handful available just a few years ago to 70 at the end of August—and with current holdings of $86 billion, account for over half the new cash flowing into ETFs this year. As their popularity grows, some of the stranger aspects of these investing tools are revealed. For instance, bond ETFs are gaining attention because of discrepancies between what investors pay for ETFs and their net asset value (NAV), or the aggregate value of the underlying holdings.
Generally speaking, a mechanism called in-kind redemption keeps ETFs trading close to their NAVs. Throughout the trading day, the fund periodically publishes a list of its portfolio holdings and their NAVs based on recent prices. Authorized financial firms can present the fund with a basket of those listed individual securities in exchange for a "creation unit"—basically a set quantity of shares in the ETF. If the ETF price rises above the holdings' NAV, the arbitrage mechanism works in reverse: Banks exchange shares of the ETF for the underlying individual securities. However, when liquidity dries up (think last fall's credit crunch) the ability to trade the underlying bonds can also freeze, causing the arbitrage mechanism to stall. If bond ETF prices drop while the NAV stagnates without new bond prices to factor in, the ETF can trade at a discount to NAV.
With markets functioning more normally again, bond ETFs now largely trade at a slight premium. Although different ETF providers employ varied pricing methods, iShares (the largest ETF family) calculates NAVs for its bond ETFs using the underlying bonds' "bid" price (what the buyer is willing to pay for the bond) rather than the higher "ask" price (at which the seller is willing to sell). As a result, the NAV iShares calculates is lower than the actual cost of buying the bonds, causing its ETFs to trade at a natural premium to NAV. But this is just wonky accounting. With bonds, the bid-ask spread is typically larger than with stocks because of the liquidity difference (stocks are generally more liquid than corresponding corporate bonds, municipal bonds, and specific asset-backed securities) and because of the inclusion of bond dealer commissions. If iShares priced its bond ETFs at the "ask" price instead of the "bid" or somewhere in between, the ETF premium would be considerably smaller.
What does all this mean for the investor? Essentially, it's a lesson in the hidden complexities of ETFs and their potential pitfalls—but probably not much else financially. This built-in accounting premium typically exists when investors both buy and sell ETFs, so it has little impact on returns. In rare instances, the ETF premium could swing to a discount as it did in 2008, but that only affects investors selling at that point. In fact, investors purchasing bond ETFs at that time got quite a deal by buying shares below NAV.
Again, ETFs are a great tool, but not a panacea. Bond ETFs provide bond investors, especially those with portfolios below $1 million, with less costly access to diversification and smaller transaction costs.
On the whole, ETFs are good for capturing the returns of a category instead of simply obtaining a single holding. But note: Expenses, fee structure, and NAV issues (like those detailed above) mean investors still need to do plenty of work to understand what they're getting into. ETFs can be fine and good for investors and certainly a positive innovation in capital markets, but the specific application must be considered to determine if they are the most optimal investment vehicle.