ETFs Are Really, Really Good, But Are Not Perfect

Watching and reading Herb Greenberg’s piece on Bond ETFs  http://www.cnbc.com/id/48973149

The story relates to news from Blackrock about recently convincing an institution to move from individual bonds, to using iShares Bond ETFs.  The simplicity of use of ETFs, combined with the complexity of trading and managing bonds were drivers of the decision

Herb wonders out loud, how, what are the implications of taking something complicated and making it less complicated?  Specifically, he mentions, taking illiquid bonds, and “making” them liquid via ETFs, must have some downside, but Herb does not speculate on what that is.

The reason why, the institution would make the change gets to the heart of the innovation behind ETFs.  When you think about it, if you are a stock investor, ETFs are not that impressive.  You are used to the transparency of buying stocks; you are used to the benefits of exchange trading with limit orders, and various trading tools to help you manage costs and risks.

The real innovation was for mutual fund investors.  It was those investors who would from time to time ask, why can’t I make my trade now, or why can’t you tell me the price I am paying for your Fund, right now?  This is where ETFs provided their biggest benefit.  They took a product, mutual funds, which initially were accessed via “check and app”, and put the access and trading on the exchange.  You still get the benefits of a pooled investment product (and now with active ETFs, professional money management), but you also can buy or sell immediately and know the exact price, and still use the same trading tools that stock investors have enjoyed to manage costs and risks.

This is the same innovation in the bond space.  Trading bonds is not an easy process.  There isn’t a centralized exchange, and while there are many services that consolidate pricing, the best bond managers have the best bond trading desks, and the best bond traders have many contacts and deep relationships to get the best availability and pricing.

I think this institution is one of many that will make this decision.  In fact, as more capital moves to access bonds via ETFs, look for even more granularity in the bond strategies being offered in an ETF structure.

With all of that said, there can be some challenges trading bond ETFs.  Most notably is potential trading at premiums and discounts.  See the chart below for HYG.  As you can see, there are periods of time where the ETF is trading away from the indicative value.  Is that too much to stay away?  I don’t think so for two reasons, one, trading bonds is a bigger pain with much bigger cost challenges, and two, the indicative value isn’t always the best representation of the true value of the ETF.  This can be the case for international ETFs (where the underlying market isn’t open during US trading hours), or for products such as high yield, where you have a variety of prices, and often stale prices, that an indicative value cannot adequately capture.

Selfishly speaking, I should say, you have less of the premium and discount issue, when you have a “select” basket of high yield bonds, such as one you might find in an actively managed ETF!

More On the Indicative Value

Keep in mind, indicative value, is a third party calculation disseminated every 15 seconds by the listing exchange for the ETF, and based on the underlying holdings.  So, for example, the indicative value for SPY is very easy to calculate, because the underlying stocks are liquid (and traded in the US).  As compared to an ETF like EFA, which is based on international stocks, the indicative value is not helpful, because the stocks are not trading during the most of the trading day of the US market.  The indicative value for a high yield ETF is somewhere in between – keep in mind (because of the “non-exchange” aspect of bonds), the pricing on bonds is not always that great for being used in an indicative calculation because some bonds won’t trade for days or weeks or months. (Especially good ones where people want to hold them to maturity).

You can view the indicative value for any ETF on Yahoo Finance using the following structure:

^ (Shift + 6), ETF Ticker, – (Dash), IV

^SPY-IV

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