This is totally true. The problem is that because bonds don't trade often, it's hard to make an index ETF based on them. You're basically asking something to be revalued multiple times a day when the holdings might get their price updated (via a trade) once a week or even once every month.
It is right. Most bond ETFs (and some stock ETFs) buy only a statistical sample of the index, not the whole thing. It usually works fine.
> For bond index ETFs, the sheer number of issues in their target indexes and the illiquid nature of many of these issues make full replication of the benchmarks prohibitive. Instead, most bond index ETFs replicate their benchmarks through a sampling approach.
> Managers create samples that aim to match the fundamental characteristics of the bond indexes across such areas as: [...]
That's meant to be the main purpose for the ETFs. As an easy way for retail investors to buy into the market with regular purchases to take advantage of cost averaging.
Not for frequent trading as a mechanism to proxy the market.
My understanding is that there are markets where bonds can be bought and sold. An ETF of bonds is just a large fund holding a set of bonds and trying to keep track of their current value.
Since you know what the return on the bond is, at what price, interest rate and time, you can very easily assess the current value of a bond, especially compared to what you might make if you just bought GICs at the current rate. An interest rate hike today lowers the sell price of bonds purchased at yesterday's rate.
This assumes you can extrapolate the interest of ETFs. There are some reasons why it might not:
- Index ETFs are becoming a huge part of the market maybe leading to unexpected results.
- We’re in a completely different situation of monetary policy. Japan is the most similar we can compare to and there it lead to a stagnating stock market.
- if the Fed decides to change its monetary policy in some years there will be significantly less money available for the stock market
- the economic position of the US is changing dramatically compared with the last 50 years.
I am actually becoming a bigger fan of etfs. Generally lower fees, can set a limit instead of buying/selling at end of day blind, and you actually get the dividends from the stocks for a dividend etf.
I am not at all clear why you wouldn't do this if you are just tracking an index.
It's much easier to do this with Commodity ETFs and Futures.
Doing it with equities or baskets of equities gets very complicated and if you read the prospective of most ETFs pretty much all of them track the indexes within some margin of error.
Commodity ETFs on the other hand have an underlying asset that will expire or require taking delivery. Most of these ETFs are managed by a group of less than 10 people. They simply do not have the resources to take delivery of an underlying asset. They don't deal with the hassle of storing / taking delivery unless things are really out of whack. Therefore, as a the underlying futures contracts approach maturity, they need to rebalance their portfolio, almost daily, and at minimum once every couple months. In a contango market, it is very easy to front run these funds compared to ETFs that track equity indexes.
I should know, this was my primary trade 4 years ago before quantitative easing killed all volatility in the market.
That being said, the Russell 2000 index is rebalanced only once per year. Opportunities to front run that index with the futures contracts are one of those trades that I miss dearly.
Just to add to your first point, it's much harder to 'game' these pre-existing indices and ETFs than it would be to game some novel and arbitrary selection criteria. These ETFs have been 'vetted' by the market over the course of many years.
Ah I see, thanks, I wasn't aware of that mechanism. So you can basically exchange the ETF for the actual held securities at any point, which keeps the price near that of the securities, pretty clever.
There's a few faulty assumptions that might apply to more liquid and efficient markets but do not apply to corporate bonds. Corporate bond liquidity is minuscule and many create/redeems are done with incomplete baskets vs actual underlying. One of the reasons why the Fed decided to include ETFs in this facility is because the ETFs were trading at a steep discount to NAV at some points earlier this year. For example, SPY's largest discount to NAV this year was around 80bps. For LQD (the largest and most liquid IG ETF), the largest discount was close to 5.1%. Discounts to NAV of that size are not academically arbed away with illiquid underlying assets because there's no liquidity or price discovery happening in those assets either.
Well, stupid question then: why would this prop up the debt market? They're just buying tokens redeemable[1] for a basket of bonds. How does that prop up (the underlying) bond prices? Or their liquidity?
ETF prices are pretty firmly anchored to the underlying bond basket prices, due to arbitrage, so prices only flow from the bonds to the ETF shares, never the other way around. Is there a dynamic I'm missing whereby the purchase of ETFs make the bonds more valuable on the market?
For an analogy, let's say there are coupons you can redeem for a 20-lb turkey at Trader Joe's (analogous to bond ETFs, which are redeemable for baskets of the underlying).
Let's say they trade on a secondary market (like those coupon selling sites) at a stable discount to the market price of the turkeys at TJ's. Let's say I go out and start buying up the coupons with reckless abandon.
I accept that they would then trade at a smaller discount to TJ turkeys. But why would that raise the market price of the turkeys themselves? Nothing about that makes the turkeys themselves more in-demand, does it?
[1] which is how I understand ETFs to work and maintain value parity
The problem is usually stated in that the ETFs have a lot more liquidity than the underlying constituent bonds. This causes questions about what will happen if the market freezes up even more -- you might find wild deviations of ETF prices from NAV.
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