Welcome to the second installment of our Master Class on bond ETFs, where we go beyond the basics to learn how these funds work and gain an understanding of their features and benefits. Last time, we talked about the three key elements of a bond ETF. Now that we’ve laid the foundation, the next concept to tackle is how they compare to stock ETFs.
Stock ETFs and bond ETFs actually have quite a few things in common. Both vehicles typically track an index, both trade on an equity exchange, and both give investors exposure to a diversified portfolio of securities in one trade. However, because stocks and bonds trade very differently, it stands to reason that stock and bond ETFs would differ as well. In particular, it’s helpful to keep the following things in mind:
Stocks trade on an exchange where their prices are publicly available throughout the day. There is generally an active secondary market for most stocks, meaning that buyers can typically finds 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 trade over-the-counter (OTC) where their 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 bonds they want to sell. It also can 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.
So how do these differences affect bond and stock ETFs? The impact can be seen in two big ways:
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. 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.