junk bond ETFs underperforming in a down market: it’s the nature of the beast

ETFs

ETFs are a great innovation, in my view.  Legally, they’re set up as investment corporations, like mutual funds (read my posts on ETFs vs. mutual funds for more details).  But, unlike mutual funds, which process buys and sells in-house (and charge a recurring fee to holders for doing so), ETFs outsource this market-making function to Wall Street brokerage firms.

This difference has several consequences:

–no recurring fee, so lower overall fund expenses,

–you can buy and sell all through the trading day, instead of selling at closing net asset value,

–unlike a mutual fund, an ETF holder has no guarantee he can transact at NAV, and

–you pay the broker a commission and a bid-asked spread when you transact (the second is an “invisible” cost that may offset the advantage of lower fund fees).

If you’re a buy-and-hold investor (the wisest course for you and me, in my opinion), ETFs have it all over index funds, especially for very liquid products like an S&P 500 index.

what about junk bond ETFs?

Why, then, have junk bond index ETFs been seriously underperforming their benchmarks during the current period of rising interest rates?

Several obvious factors:

–junk bonds aren’t particularly liquid.  Many don’t trade every day.  In fact, junk bond fund and ETF managers employ independent pricing services, which estimate the value of bonds that haven’t traded that day, in order to calculate daily NAV.

This means that if redemptions come, a junk bond index fund/ETF has to go hunting for buyers and won’t get the best prices for the bonds it’s selling.  The sharper-than-benchmark falls in ETF NAVs suggests they’re taking big haircuts on the positions they’re liquidating.

–ETFs attract short-term traders, who are more prone to redeem

–ETFs can be sold short, adding to downward  pressure

–ETFs don’t accept dribs and drabs of redeemed shares from the investment banks it uses as middlemen.  Brokers hold until they have minimum exchangeable quantities.  While they’re waiting, they may hedge their positions–meaning they may short the ETF, too.

Ouch!

One not-so-obvious one:

Unlike a mutual fund, the broker you’re buying and selling through has no obligation to transact for you in an ETF at NAV.  Quite the opposite.  Your expectation should be that the broker will make a profit through his bid-asked spread.

The broker typically has a very good idea what NAV is on a minute-to-minute basis.  Individuals like us usually don’t.  NOt a great bargaining position to be in.

In addition, in contrast with an S&P 500 index fund, where the broker gets an up-to-date NAV every 15 seconds, no one knows precisely what a junk bond fund NAV is at any given time (certainly the broker has a better idea than you and me, but that’s another issue).  This uncertainty makes the broker widen his spread.

On top of that, when a broker is taking on more inventory of shares than he feels comfortable with, he’ll widen his spread further, to discourage potential sellers from transacting.

Brokers know how much money they make through these spreads.  No one else does.  We do know, though, that in past times of stress the last trade of the day in a less-liquid ETFs has often been substantially below NAV.  My guess is that recent junk bond ETF sellers have paid a hefty price through the bid-asked spread to get their transactions done.  If you’re one, compare your selling price with that’s day’s NAV and see.

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