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.

In reality though, bond ETFs tend to trade at a premium when lots of investors are buying them, and at a discount when lots of investors are selling them. They suffer from a classic directional stampede effect, and while mutual funds have the same problem, at least the purchase and sale of their securities can be more thoughtful. This dynamic-the majority of investors buying at a premium and selling at a discount-is an undeniable black mark on fixed-income ETFs, making it difficult to advocate their use for a conservative and core allocation within a client's portfolio.

Additionally, it should be noted that the indices that many popular bond ETFs represent have been around for decades, and are nearly impossible to replicate. For example, a key fixed-income benchmark, the Barclays Capital U.S. Aggregate Bond Index, represents some 8,000 individual bonds, many of which are illiquid and trade infrequently.

So ETFs that try to deliver those exposures must partake in a representative sampling strategy, delivering a portfolio exhibiting similar risk/return characteristics to the broader benchmark. While this sampling strategy is also used by fund and individual bond portfolio managers, it can pose unique challenges to ETFs, especially when it forces purchases or sales of securities at points in time that may not be beneficial to the underlying shareholders.

The more active management strategy of fund and individual bond managers provides the flexibility to manage the rebalancing process more effectively based on market conditions.

In fact, many active managers seek to exploit this pitfall of bond ETFs, which because of the narrowly defined exposures they must maintain, are buying and selling securities at fairly predictable points in time. Indeed, it is not uncommon to see the prices of securities that are a mainstay of bond ETF portfolios get run up in the days before their rebalancing purchase transactions, or to see active managers dumping bonds that they know are falling out of the index sampling portfolio in advance of ETF selling.

Another problem with this index construction sampling is that most tend to either weight bonds by the market size of existing debt, meaning you automatically allocate more money to more indebted and risky issuers, or use credit ratings to determine an issuer's eligibility, which may or may not be reliable these days.

Admittedly, some of these same issues are also present with mutual fund and individual bond portfolio management, though it is less frequently the case. However, it is worth noting that constant ETF industry innovation means there are some new actively managed ETF products that seek to avoid these pitfalls. However, ETFs' biggest problem-the aforementioned issues with dislocations between NAV and share price-are here to stay.

At the end of the day, advisors and investors must weigh the benefits and drawbacks among the varying methods of garnering bond exposures and decide what is best for the client, being careful not to be lulled into the ease and trendiness of the current product proliferation cycle that have made ETFs a hot ticket item. A mutual fund might be a better choice, without the NAV and share price dislocation issues of ETFs, though they are usually more expensive, and sometimes less tax efficient, and intraday trading is not available.

Individual bonds provide a predictable income steam, as well as return of principal-something that traditional bond mutual funds and ETFs cannot. But the ability to diversify and have access to expertise from a credit and trading perspective is paramount when considering that route.

For these reasons, many financial advisors should consider using traditional bond mutual funds and ETFs as exposure vehicles while building a professionally managed bond portfolio to represent the core fixed-income allocation. In this way, an advisor can also customize the core bond portfolio to reflect the tax status, cash flow, liquidity and credit risk of the client, complementing the individual securities with ETF or mutual fund investments as necessary, with eyes wide open about the potential drawbacks.

Michelle Knight is chief economist and managing director of fixed income at Silver Bridge (www.silverbridgeadvisors.com), an independent wealth management boutique.