The flaws of fixed income ETF’s

By: ispeculatornew
Date posted: 10.21.2009 (5:00 am) | Write a Comment  (4 Comments)

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bondsIt is no secret by now, I am a fan of ETF’s (especially when compared with mutual funds) and I have discussed in the past how fixed income ETF’s have been receiving very important flows in the past year or so. You will not be surprised to hear that I am one of those new investors. But ETF’s are not perfect, especially fixed income ones. There has been increasing attention towards the different problems that can be found in fixed income ETF’s in articles by the mainstream media.

The main problem I would say is that most fixed income ETF’s invest in a very large amount of bond issues. This is logical of course because it avoids too much concentration in a single name/issue. Unfortunately, this does create problems. One of the main advantages of ETF’s is the liquidity offered in most cases. This liquidity comes from the fact that at any point, an investor can sell the underlying securities and buy the ETF if ever the pricing of the ETF is incorrect. The opposite is also done of course. However, this “arbitrage” is rarely if ever done on fixed income ETF’s because the costs are too important for a hedger to be able to do this trade. Since bonds do not trade on a market, buying or selling every issue that the ETF owns can become quite an adventure. Because of that, fixed income ETF pricing is more “imperfect”.

Another main critic is that ETF’s usually track indexes. For equity ETF’s, they usually track the main indexes or specific countries or sectors.  For bond ETF’s, it is more abstract. There are of course many different bond benchmarks. But tracking them is more of an imperfect science. These benchmarks often have issues that are almost impossible to trade, especially in the quantities required for the ETF. So these funds are left with a choice of how to correctly track the benchmark without having the exact components. There are many ways to do this but they are all imperfect. So fixed income ETF’s do suffer from more tracking error. It can be positive or negative but it is a problem for most investors.

And finally, there is less transparency for fixed income ETF investors. They can get a list of every bond owned by the ETF but they will not know which bond is being sold, bought and why. This can make a major impact and it is a phenomenon that is not much of a problem in equity ETF’s.

Do fixed income ETF’s have many significant flaws? Absolutely. But I think it is critical for investors to think about the alternatives. If they want to avoid the ETF, they can either buy bond issues themselves or purchase mutual funds. Of course, I would never recommend getting a mutual fund. And the next time you buy a bond, take a close look at your purchase price. Spreads are very high and since the market is illiquid and non transparent, investors, especially smaller ones are often taken advantage of. For these reasons, you can still count me in as a fixed income ETF investor

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4 Comments

  1. Comment by Zavi — October 21, 2009 @ 7:12 am

    IS, I’m also sold to fixed income ETFs. They are a great way for me to diversify risk. Yes, they are an excellent asset allocation alternative to individual bonds (no one bet) and bond mutual funds (lower fees) hehehe Also, bonds’s credit quality are monitored and target maturities are maintained. So I do not have to worry. Good post.

  2. Comment by Frank — October 21, 2009 @ 7:30 am

    Little comment here. Right now, US bond market pricing does not reflect true market conditions. The problem is the intrusion of the US government with their massive government debt issuance and spending (especially mortgage-back securities and Treasuries), the Fed’s zero percent interest rate policy, … And Fixed Income ETFs represent the actual value real investors were willing to put on that basket of bonds…

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