Barclay's is finding the ETF space is getting crowded. The ETF giant, the first firm to offer fixed-income ETFs in 2002 and the only one to do so continuously until last year, suddenly is facing stiff competition from a slew of new products from State Street Global Advisors, Vanguard, PowerShares Capital Management, Claymore, Van Eck and others.
The number of fixed-income exchange-traded funds has exploded to include both portfolios based on broad indexes as well as ETFs consisting of emerging market, municipal and high-yield securities. As of November, there were 43 fixed-income ETFs with $31 billion in assets, compared with six bond ETFs with $20.5 billion in assets at the end of 2006, according to the Investment Company Institute.
Of the 59 new ETFs that began trading on the American Stock Exchange in the last half of 2007, 23 were fixed-income. Given that bonds represent around half of the average investor's portfolio and about one-third of mutual funds, but less than 6% of total ETF assets, the field is open for more fixed-income ETFs to debut.
Initial market entrants provided exposure to broad Treasury and government bond indexes, while newer and upcoming products break down the market into narrower segments. In September, Barclay's Global Investors opened the door to national municipal bond ETFs with its iShares S&P National Municipal Bond Index Fund (MUB). Van Eck, State Street Global Advisors and PowerShares subsequently joined the municipal bond party with Market Vectors-Lehman Brothers AMT-Free Intermediate Municipal Index ETF (ITM), SPDR Lehman Municipal Bond ETF (TFI) and the PowerShares Insured National Municipal Bond Portfolio (PZA). State Street and PowerShares filled a gap with their own versions of New York- and California-specific funds.
October saw the debut of one ETF offering nondollar, denominated exposure on the fixed-income side and one that invests in dollar-denominated bonds of emerging market countries. The SPDR Lehman International Treasury Bond ETF (BWX) has accumulated $178 million in assets and the PowerShares Emerging Markets Sovereign Debt Portfolio (PCY) has drawn about $30 million.
High yield has also been hot. State Street Global Advisors launched its high-yield bond ETF in December, becoming the third company to issue a high-yield bond ETF. The SPDR Lehman HighYield Fund (JNK) joined two existing competitors, the PowerShares High Yield Corporate Bond Portfolio (PHB) and the iShares iBoxx $ High Yield Corporate Bond Fund (HYG).
Look for even more variations on bond themes this year. Rockville, Md.-based ProShares has filed for short and ultra-short funds tied to four major bond benchmarks: the Lehman Brothers 7-10 Year U.S. Treasury, Lehman Brothers 20+ Year U.S. Treasury, iBoxx $ Liquid Investment Grade, and iBoxx $ Liquid High Yield. The firm has made its mark on the equity side with a roster of bet-against-the market funds.
Pros and Cons
Bond ETFs sport low expense ratios and offer a number of other advantages over traditional index funds, the competitor they resemble most. Investors can buy or sell them at intraday prices, and use stock trading techniques such as buying on margin, placing limit orders or selling short.
ETF sponsors say that the funds can help many investors achieve better liquidity and lower costs than individual securities, particularly in illiquid markets such as municipal bonds. "Embedded costs can be 2% or more when you're talking about a $20,000 municipal bond. We charge a fee of 20 basis points a year and have institutional buying power," says Tom Anderson, head of ETF research at State Street Global Advisors. "ETFs are often less expensive than bond laddering, and with the increasing number of options available, it is possible to tailor duration exposure."
But the new world of bond ETFs requires a little more skill to navigate than mutual funds. Although pricing is efficient for a handful of actively traded ETFs such as iShares Lehman Aggregate Bond (AGG) or iShares Lehman Short Treasury Bond (SHV), the newer products that don't have a big audience so often have wider bid-ask spreads, cautions Herb Morgan, president of Efficient Market Advisors in Del Mar, Calif. To narrow the gap, Morgan places a limit order to buy or sell a security at a specific price or better, rather than a market order. "If an ETF has an ask price of 101.65 and a bid price of 101.46, I might put in a limit order to go in somewhere around 101.55," he says. "It may take 10 or 15 minutes longer but it's definitely worth the time."
Hildy Richelson, bond specialist and author of Bonds: The Unbeaten Path to Secure Investment Growth, sees potential problems down the road with less actively traded ETFs. "I think big disparities between bid and ask prices are going to be an issue with the new municipal bond exchange-traded funds, and there may be higher-than-expected turnover when the bonds get called," says Richelson, who believes that individual municipal bonds are less expensive and more predictable for the typical buy-and-hold investor. She adds that bondholders also have more flexibility because they can tailor the duration and maturities in their portfolios to individual needs, lock in yield for a specific period of time and know what they are getting back at maturity.
Fluctuating discounts and premiums to net asset value can also complicate pricing. Like their equity counterparts, ETFs that invest in bonds have a price at which they trade, their market price, which changes throughout the day. Their net asset value, calculated as the value of the underlying securities (less fund liabilities) divided by the number of shares outstanding, is also updated continuously.
Because bond quote and pricing mechanisms are less developed than those for stocks, calculating underlying values can be trickier. Differences between the market price and net asset value are usually fairly small but they can widen from time to time with some ETFs. The iShares iBoxx $ High Yield Corporate Bond Fund has traded at a premium ranging from 1% to 3 ½% since its launch in April 2007, according to the Web site http://etfconnect.com, while Ameristock/Ryan 5 Year Treasury ETF's (GKC) discount has ranged from less than 1% to over 6% since it started trading in July.
Beyond pricing, those considering bond ETFs should look at other factors, including:
Tracking error: Most bond ETFs use optimized sampling techniques to replicate indexes with thousands of better known bonds, while some use just a small fraction of the bonds from their respective universes. Barclay's S&P National Municipal Bond Fund uses 54 holdings to replicate an index with over 3,000 different bond issues, while the SPDR Lehman Municipal Bond ETF uses a sampling of 49 bonds to represent the Lehman Brothers Municipal Managed Money Index, which has more than 22,000 issues.
Depending on their sampling techniques and fees, several funds trying to mimic the same index can have returns that differ both from each other and the index. The oldest of three indexes ETFs to mirror the Lehman Aggregate Bond Index, iShares Aggregate (AGG), recently under performed its benchmark by 28 basis points with a three-year annualized return of 3.92%. The tracking error was eight basis points more than the ETF's expense ratio.
Vanguard Total Bond Market Index (VBMFX), a mutual fund that also seeks to replicate the Lehman Aggregate Bond Index, trailed its bogey by 6 basis points over the same period. Two ETFs based on the index, Vanguard Total Bond Market (BND) and SPDR Lehman Aggregate Bond (LAG) were introduced last year and have expense ratios of 11 basis points and 13 basis points, respectively. Also keep in mind that many new "rules based" indexes were created for specific products and are likely to perform differently from more established indexes.
Costs: Fixed-income ETFs are cheaper that most bond mutual funds, with expense ratios ranging from 11 basis points for Vanguard's offerings to 50 basis points for more exotic vehciles such as high-yield or international and emerging market debt. The average expense ratio for a bond fund is 1.08%, according to Morningstar, giving the ETFs a distinct cost advantage overall. Still, some index funds have expense ratios similar to those of bond ETFs, and you don't need to pay brokerage commissions or worry about spreads when you buy or sell them. For smaller investors who don't want to incur commissions and bid-ask spreads, or investors who dollar-cost average or rebalance frequently, a no-load index fund is probably a better bet.
Distributions: ETFs are designed to limit short- or long-term capital gains distributions so investors should only have to pay applicable taxes on interest income. However, it is possible that some ETFs may need to make changes to reflect the impact of maturing or called bonds in a target index, creating a potential for some capital gains distributions. While it is encouraging that some of the oldest bond ETFs have yet to distribute gains, the introduction of more corporate and municipal ETFs could change that. Also consider whether a client wants to take distributions in cash or reinvest them. Some brokerage firms will not reinvest ETF distributions and those that do may charge additional commissions.
Staying power: Morgan is concerned that some of the new bond ETFs from sponsors that don't have a lot of marketing and financial muscle behind them may not survive and will need to be liquidated, creating unforeseen investment and tax consequences. His advice: "Stick with the better known players."