Bond ETF investors need to understand that the tracking index may work differently than benchmarks used by stock funds, a recent report warns.
Most stock ETFs utilize a market-capitalization approach, assigning the largest weighting to the biggest companies.
Like stock ETFs, bond funds also weight components by market capitalization. This means that companies or countries with more outstanding debt would have larger weightings in the index. However, bond investors would not prefer companies or countries with high debt burdens as this would increase exposure to potential risks. [Four Things You Should Know About High-Yield Bond ETFs]
“Simply allocating the most weight to the largest debtors is problematic,” Shane Shepherd, head of fixed-income research at Research Affiliates, said in a Wall Street Journal article.
“Lower credit quality isn’t necessarily a bad thing for an investor who wants to take more credit risk,” Brian Kinney, global head of fixed-income beta solutions at State Street Global Advisors, the firm behind the SPDR ETFs, said in the article.
Additionally, due to the multitude of bonds available, bond ETFs will only be more selective in sampling an underlying benchmark – there are about 40,000 corporate bonds issued by U.S. firms outstanding, whereas 4,488 stocks were listed in the U.S. as of July 2. [Bond ETF Market Forecast to Hit $2 Trillion]
Consequently, bond ETFs may only represent a fraction of the overall bond market they seek to track. Moreover, this may lead to tracking errors, or deviations between the bond ETF’s performance and that of the underlying index.
The popularly monitored Barclays U.S. Aggregate index may not be the best benchmark for most long-term fixed-income investors, as the index has a heavy weighting toward U.S. government bonds, which are subject to interest rate risks – as interest rates rise from their historic lows, the bond prices will fall.
“In a rising-rate environment, those government bonds are the riskiest,” Rich Wiggins, a senior consultant at Summit Strategies Group, said in the article.
For more information on ETF indexing, visit our indexing category.
Max Chen contributed to this article.