Exchange-traded funds that track bonds have been running into trouble trading at prices that match their underlying values, raising questions about one of their key promises to investors.
On Sept. 18, Barclays PLC's closed at a price 8.4% below the underlying value of its securities. The previous day the ETF closed at a discount of 3.2%. Two days earlier it was down 2.4% from its underlying value. While the fund has lately posted more accurate prices, investors that sold shares on any of those days may have taken a significant haircut.
"Because the market is so wild, some of these are trading like closed-end funds that drift from their NAVs," says Morgan Stanley ETF analyst Paul Mazzilli, referring to "net asset value," the industry term for the per-share value of a fund's holdings.
ETFs tracking investment-grade corporate bonds as well as other types of fixed income such as municipal bonds and preferred shares also had problems last week. In fact, of about 50 domestic fixed-income ETFs traded in the U.S., six missed their mark by 5% or more on at least one day. In all, 22 were off by 2% or more at least once. Moreover, while recent headline-grabbing events have exacerbated bond ETFs' problems, a number have been showing signs of trouble all year.
Wide swings away from their NAVs are supposed to be unusual for exchange-traded funds, open-end mutual funds that trade on an exchange like a stock. The vast majority of ETFs are index funds, designed to allow investors to buy baskets of stocks throughout the day at prices that closely reflect the values of their holdings.
How accurately do ETFs trade? One well-known fund, the SPDR Trust, Series 1, which tracks the Standard & Poor's 500-stock index, has missed its benchmark by more than 2% only twice in almost 4,000 trading days.
Fund companies point to the benefit in their advertising. "Precise in a world that isn't" is the slogan of one recent ETF ad. "Designed for better market tracking," reads the text of another.
That promise of certainty -- the result of a special mechanism that allows ETFs to create and eliminate shares to meet market demand -- has helped the funds collect more than $580 billion in assets from investors from individual investors to hedge funds. By contrast, closed-end funds, which don't have ETFs' special mechanism, have roughly half as many assets, despite having been around decades longer.
While ETFs still have a strong track record of accurately matching benchmarks, their reputation has occasionally been tarnished as ever more complex funds have hit the market. In 2007, ETFs that tracked crude oil came under scrutiny when the funds failed to keep up with rising oil prices.
Last week a pair of ETFs designed to help investors bet against financial stocks stopped functioning properly after the government restricted short selling.
Problems with bond funds could be more far-reaching, however, because many are meat-and-potatoes investments designed for the portfolios of small investors.
Investors should view bond funds' recent results as an exception, not the rule, says Noel Archard, head of U.S. iShares product development at Barclays. Amid last week's turmoil, ETFs continued to trade, even as markets for some of the risky bonds that the funds own all but froze, Mr. Archard says. That means ETF traders had to guess the securities' value, even as bond benchmarks reflected stale prices.
"It's a live estimate of where these should be valued," he says. In that sense, ETF prices are "more accurate" than market quotes for the funds' underlying values which are based on recent trading prices for individual bonds.
Bond funds are a relatively new addition to the ETF market, but one of the fastest-growing. A handful appeared in 2002, but no more were started until last year, when fund companies suddenly rushed out more than 40 new ones in an attempt to capitalize on ETFs' burgeoning popularity.
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