Here’s a little history lesson for you: Launched in 1993, the first exchange traded fund (ETF) was an equity fund, a basket of stocks that reflected an index. The first bond ETF started trading nearly a decade later. The introduction of the bond ETF may not seem like a big deal, but it was because of how different stocks and bonds are.
Stocks
Stocks trade on an exchange. Their prices are publicly available throughout the day. There is generally an active secondary market for most stocks, meaning that buyers can typically find sellers and sellers can typically find buyers. Everyone in the market can see at what price they can buy or sell a stock at a given point in time.
Bonds
Bonds trade over-the-counter (OTC). Prices are negotiated privately between buyers and sellers. It can be hard for an investor to find the bonds that they want to buy and it can be difficult to get a price on the bonds they want to sell. It can also be difficult to find information on where bonds are trading in order to get a sense of what a fair buy or sell price should be.
Stock ETFs and bond ETFs, on the other hand, actually have quite a few things in common. Both typically seek to track an index, both trade on a stock exchange and both give investors exposure to a diversified portfolio of securities in one trade. But there are two key differences.
Two Key Differences
1. How they are managed
An ETF portfolio manager (PM)’s number one goal is to track the performance of the fund’s target index as closely as possible, after fees and expenses. The difficulty of this task can vary greatly depending on how accessible the securities in the index are. For example, it’s relatively easy to trade the large cap stocks in the S&P 500 Index, whereas it’s harder to trade the less liquid stocks in the MSCI Frontier Market Index. Tracking a bond index adds another layer of complexity. Some bond indexes are huge—think hundreds or even thousands of bonds. And since bonds may be less liquid than stocks, it’s often impossible for an ETF to own every security in a given index—some of those bonds are simply unavailable. Instead, bond ETF managers use a “sampling” approach where they try to replicate the risk and return characteristics of the index using a smaller portfolio of available bonds. Tracking a bond index can be a challenge, particularly in a highly illiquid sector such as high yield. The PM of the ETF is constantly working to reduce portfolio tracking error vs. the fund’s index. And since reputable ETF providers leverage economies of scale and bond desk relationships in order to facilitate trades in illiquid securities, investors actually get exposure to a wider variety of bonds than they would likely be able to access on their own. Basically, the bond ETF does the legwork of tracking down the bond and seeking to ensure a fair price for you.
2. How they calculate underlying value
Another key difference between bond ETFs and equity ETFs is the way that they calculate underlying value. Since stocks trade on an exchange, the public can see each stock’s current price at any point during market hours, as well as a closing price at market close. ETF providers use stocks’ prices to calculate an ETF’s intraday underlying value throughout the trading day, and the closing net asset value (NAV) of an equity ETF is typically very close to the ETF’s closing price. Bonds trade OTC, and there’s typically no central market where investors can see where bonds were bought and sold. At the same time the majority of bonds do not trade every day and so their value must be estimated based upon available market information. This means that the calculation of a bond ETF’s underlying value is going to be less precise than a stock ETF’s underlying value. As a result, bond ETFs tend to experience more premiums and discounts, or deviation between the closing ETF price and the closing NAV. But while an ETF’s NAV is the best estimate of that fund’s underlying value, it’s still just an estimate—especially for bonds. It’s not an actionable price that investors can use to transact in the portfolio of 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. Often when we talk about how innovative bond ETFs are, this is what we’re referring to—the bond market simply didn’t have this kind of price transparency before bond ETFs came along.
If history isn’t your subject, just keep in mind that despite their differences both stock and bond ETFs provide an efficient way to invest in markets. And that is one lesson worth remembering.
Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog.