Practical Ways To Hold Down Costs With Bond ETFs

August 06, 2009

 

The Bottom Line

What does all of this mean for investors?

For starters, the data show that premiums and discounts are not an issue for liquid markets like Treasuries. Treasury, TIPs and agency bond funds trade at tight spreads to their NAV. Although they are not studied, it’s reasonable to expect international Treasury ETFs with significant asset and trading volume also do a good job of estimating the fair value of their underlying markets.

As you move into less liquid corners of the market, however, premiums and discounts become an issue. Many of the funds in this study closed at a premium every single day of the quarter, and the variability of that premium was relatively small. That consistency means you’re unlikely to pay a premium when you buy, but then receive a discount when you sell.

What could happen, however, if investors started redeeming these funds en masse?

The data show that there is some inefficiency in the creation-redemption mechanism; that’s why funds that use in-kind creations in illiquid markets tend to trade at a premium, while funds that use cash creations tend to trade at a discount. If the fund flows went against these ETFs, it’s not clear what would stop them from swinging to a discount.

In normal circumstances, however, bond ETFs do seem to provide a level of granularity and open up unique asset classes at a level that’s not available anywhere else. For investors looking to more illiquid corners of the market, it will pay to keep an eye on premiums and discounts. Otherwise, they might run the risk of overpaying on the high end when buying—or, sell too cheap when they’re getting out.

 


Matt Hougan is managing director of ETF analytics for Index Publications. Dave Nadig is the firm’s research director. Index Publications is the parent of IndexUniverse.com.

 

Find your next ETF

Reset All