An Exchange Traded Fund (ETF) is an investment tool, which combines the features of both mutual funds and stocks, providing multiple benefits such as diversification, liquidity and transparency. Like a mutual fund, an ETF is a collection of individual stocks or bonds that track a predefined index. Like a stock, ETFs trade on exchanges and can be bought or sold throughout the day. These features provide investors with an easy-to-use, low cost and tax efficient way to invest your money.
Originating in 1993, the first ETFs originally followed only equity indexes. It wasn’t until a decade later that Bond ETFs started to appear. While Equity and Bond ETFs display the same structural characteristics and have many things in common—typically tracking a diversified index and trading on exchanges—there are some key differences, because of the fundamental difference in stock and bond markets.
Stocks trade on exchanges, making them simple to access and value. Bonds on the other hand, trade over-the-counter (OTC). Prices are negotiated privately between buyers and sellers leading to a lack of price transparency. It can also be difficult for investors to find the bonds they want to buy. So how does this impact the management and valuation of Equity and Bond ETFs?
The objective of an ETF portfolio manager (PM) is to track the performance of the ETFs target index as closely as possible. For a simple equity index such as the S&P 500, PMs will hold all the securities in the respective weights as the index. The ability to access the constituent securities can be more difficult for broader, or less liquid indexes, i.e. the MSCI Emerging Market IMI index. Tracking a bond index adds another layer of complexity. The nature of the bond market makes it extremely difficult to exactly follow the index’s composition. Due to the enormous number of issuers and bonds within the US Aggregate bond index, bond ETF Portfolio Managers use a “sampling” approach wherein they aim to replicate the risk and return characteristics of the index using a smaller portfolio of available bonds. Large managers are able to leverage economies of scale and bond desk relationships, alleviating the legwork of tracking down bonds and simultaneously seeking to ensure fair pricing for investors.
The second main difference between Equity and Bond ETFs is the way they calculate underlying value. Price transparency in stock markets allows the price of an Equity ETF to be aligned to the value of the underlying basket of stocks, both during the day and at the close. Bond ETFs on the other hand, are often forced to rely on an estimate of Bond prices, as there’s typically no central market where investors can see where bonds were bought and sold—remember that on top of not necessarily trading every day, bonds tradeover-the-counter (OTC). This means that Bond ETF prices and the NAV values tend to deviate more than Equity ETFs, but keep in mind that NAV in the fixed income world is a best effort estimate and not necessarily an actionable price that investors could use to transact in the underlying securities. The reality is that market price of a bond ETF represents the price at which the underlying bonds can actually be traded at any given moment, derived by buyers and sellers transacting in a transparent investment tool.
The benefits Bond ETFs bring to markets have been immense. Bond ETFs have provided a price discovery tool that simply did not exist in Bond markets before. When we talk about how innovative bond ETFs are, this is what we’re referring to.
_______________________________________________________________
This material is for educational purposes only and does not constitute investment advice nor an offer or solicitation to sell or a solicitation of an offer to buy any shares of any Fund (nor shall any such shares be offered or sold to any person) in any jurisdiction in which an offer, solicitation, purchase or sale would be unlawful under the securities law of that jurisdiction. If any funds are mentioned or inferred to in this material, it is possible that some or all of the funds have not been registered with the securities regulator in any Latin American and Iberian country and thus might not be publicly offered within any such country. The securities regulators of such countries have not confirmed the accuracy of any information contained herein.