The exchange-traded fund (ETF) industry has absolutely exploded since its introduction in 1993, accumulating an astonishing $1.1 trillion in assets, according to Morningstar, causing many to question whether these vehicles will ultimately replace mutual funds and individual securities.
ETFs have won investor favor not only for their transparency and low fees, but also for their more narrow expression of exposures that allow for more strategic investments. Timber, palladium, Russian small-cap companies, frontier currencies, inverse levered REIT exposure-you name it, there is probably an ETF product for it. But perhaps most compelling, ETFs offer the ability to transact intraday, allowing for more tactical active management of client assets.
Sound too good to be true? They might be, especially when it comes to delivering exposures to the fixed-income asset classes. For unlike most equity-based ETFs, bond ETFs have not quite been what they are cracked up to be. They have instead faced liquidity complications and had difficulty accurately replicating and maintaining exposure to the vast bond market universe.
For starters, an ETF's share price, which is dictated by market demand, may often be different from its net asset value (NAV). However, we know such differences should not typically last for long, as arbitragers will quickly use the ETF creation-redemption mechanism to ensure that an ETF's share price sticks close to the value of its underlying holdings.
For equities, this process is easy, as the underlying securities are liquid. But bonds are a different animal, and many bond ETFs routinely trade with a premium or discount of 1% or more from their NAV because of the inherent illiquidity of the over-the-counter fixed-income marketplace.
Consider 2008. Investors had trouble even valuing bond issues during the credit crisis, much less trading them, and premiums and discounts in bond ETFs became extreme. For example, a popular high-yield bond ETF, the iShares iBoxx $ High Yield Corporate Bond Fund, saw its premium peak at 12.7% on December 23, 2008, while only two months earlier on October 10, the ETF was trading at a discount of 7.9%. In 2009, this same iShares fund saw several days when premiums were more than 6% of NAV, and also saw occasions when discounts were greater than 3%. Likewise, in the same quarter, the SPDR Barclays Capital High Yield Bond ETF swung from a premium of more than 9.0% on January 5, 2009, to a discount of 2.5% on February 23.
More recently, when the municipal bond market took a big hit in the fourth quarter of 2010 (following financial analyst Meredith Whitney's explosive comments predicting hundreds of billions of defaults), the hit the muni bond ETF market took was even bigger. Most ETFs' shares traded below their quoted NAVs for the entire quarter!
Keep in mind these were not small-float or sector specific funds. The iShares S&P National AMT-Free Municipal Bond Fund-which with $1.91 billion in assets is by far the biggest muni ETF-saw its NAV slip 5.5% in the fourth quarter, while its shares representing ownership of those assets sank 6.8%. Even the SPDR Nuveen Barclays Capital Short Term Municipal Bond Fund, which at $1.3 billion is the second-biggest muni ETF, reported a 1.2% decline in its NAV in the fourth quarter, while its shares sank 1.6%.
Thus, while we would all like to believe in efficient markets and the notion that any dislocations between share price and NAV would be quickly corrected, experience with bond ETFs tells us otherwise. Perhaps exacerbating the issue is the fact that ETFs can be shorted and in times of market crisis are routinely used and abused in this way by hedge funds and the like to the ultimate detriment of shareholders.
Of course, proponents of ETFs argue that these vehicles actually offer the best "true" price of the underlying market in these crisis situations. Many bonds trade only a few times a day and sometimes not for days or weeks at a time, so fixed-income securities are often not priced from real trades but from best-guess synthetic prices sourced from bond pricing services. At least with an ETF, the share price represents the actual value a real investor is willing to pay on that basket of bonds at that point in time.