One of the most common questions we get at ETF.com is, what's the difference between an ETF and a mutual fund?
Usually, our answer is some combination of "better tradability + more transparency + lower costs.” ETFs trade intraday on exchanges like stocks, they regularly disclose their holdings, and they rely on authorized participants (APs) to create and redeem shares and keep prices in line. That last characteristic helps to lower fund expenses and reduce ETFs' tax burden, and as such, attracts the lion's share of attention from investors.
However, it's easy to overlook how much tradability can matter—especially in the fixed income space, where ETFs have had a profound impact on the way people invest. Bond ETFs have created, quite literally, a fairer and more liquid underlying market—something that benefits everybody, regardless of their preferred investment vehicle.
Bond ETFs Are More Liquid
Like bond mutual funds, bond ETFs package hundreds—sometimes thousands—of individual bonds into a single portfolio at a price significantly less than the cost of going to the over-the-counter (OTC) markets and buying each bond individually.
However, unlike mutual funds, bond ETFs can be bought and sold at any time during the trading day. In contrast, mutual funds trade only once a day, after market close.
Intraday ETF trading acts like a shot in the arm of liquidity for markets that trade less frequently or on different schedules than the U.S. market. Consider municipal bonds, some of which go weeks, even months between each trade. With a municipal bond ETF, however, investors can add or reduce their positions at any time, multiple times, during a single trading day.
That's a huge plus for active traders, and indeed, the exchange-traded nature of bond ETFs has led to the curious situation of bond ETFs making their underlying markets more liquid, simply by the fact of their existence.
It's common for bond ETFs to trade with much higher volumes than their underlying bonds; for example, the iShares iBoxx USD High Yield Corporate Bond ETF (HYG) trades roughly $1.5 billion in average volume daily, while the average bond held by HYG trades an average of $2.5 million daily (read: "Are Bond ETFs More Liquid Than Bonds?").
Bond ETFs Aid In Price Discovery
But it actually goes even deeper than that, because bond ETFs aid in price discovery for the underlying bonds themselves (something that bond mutual funds, with their once-a-day trading schedule, haven't been able to do).
Because individual bonds are traded OTC, traditionally it's been difficult to assess the fair value price for any particular bond. As a result, mutual fund and ETF managers use bond pricing services to give a best-guess estimate of individual bond values. Using those bond prices, the managers then calculate the net asset value (NAV) of their funds.
However, bond pricing services aren't always on target. These services base their estimates on what prices the managers would receive were they to start selling bonds from the portfolio immediately; meaning, at fire-sale prices. That sell-at-any-cost price will always be less than what you could pay to buy the bond, which in turn depresses the NAVs of all bond ETFs.
Furthermore, pricing services still need to come up with prices for bonds that don't trade frequently, or at all, during a trading day. Often, they'll simply carry over the bond's last traded price as necessary—which can create a sharp pricing disconnect when the bond actually trades again.
ETFs, however, rely on the AP arbitrage to keep their share prices in line with NAV, a mechanism that works pretty well at keeping share price and NAV in tandem. As a result, it's common for the share price of a bond ETF to be a better approximation of the total aggregate value of the bonds in its portfolio than what could be gotten through a pricing service (read: "Fixed Income ETFs: What Happens During Bond Panics?").
Bond ETFs Don't Penalize You For Holding Them
An additional—and often overlooked—benefit of bond ETFs is that they don't penalize buy-and-hold shareholders when the underlying bond markets become stressed.
In stressed or illiquid markets, an ETF's share price may drift below its NAV by a significant amount. When that happens, it means the fund's APs and market makers believe the bond pricing service is wrong. Essentially, APs can't liquidate the underlying bonds in the ETF's portfolio for the prices reported by the pricing service; consequently, the ETF's share price develops a discount to NAV. The same thing happens in reverse for premiums to NAV.
Most of the time, AP arbitrage eventually evens out premiums and discounts, even in times of market stress. For more information on how, read "The Next Bond ETF Crash: An ETF Story."
This process is distinct from mutual funds, which guarantee investors the ability to enter and exit the fund at exactly NAV at all times, market stress or no. That's good for investors who want to sell their bond fund—but not so great for the shareholders left behind.
Mutual Fund Holders Subsidize Exit Costs
Here's why: To fill a redemption request, mutual fund managers must give the exiting investor cash equal in value to the fund's NAV. To get that cash, managers must sell bonds in the portfolio.
In normal markets, that's simple. However, in stressed markets, that's harder to do—especially since the managers won't be able to sell the underlying bonds for the prices reported by their pricing service.
As a result, mutual fund managers often have to sell more bonds than the NAV's worth to make up the difference. The shareholders who remain in the fund subsidize that cost.
Furthermore, because mutual funds process their redemptions overnight, instead of intraday, they have to keep cash on hand—creating cash drag on the fund—or maintain a credit facility, which shows up as a fund expense.
Sophisticated Trading Strategies
There are other benefits to the intraday tradability of bonds, too: You can perform all sorts of sophisticated trades on a bond ETF that you can't with a bond mutual fund; for example, you can buy bond ETFs on margin and sell them short.
You can also trade options on bond ETFs; the aforementioned HYG is popular with investors placing puts and calls (read: "15 ETFs With The Most Liquid Options").
But even if you aren't interested in these more sophisticated trading strategies, you can rest assured that bond markets are more liquid and priced more fairly than they used to be, simply because bond ETFs exist.
Contact Lara Crigger at [email protected]