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Add the bond discounts to the growing list of ETF debacles
in the current market volatility.

An 8% daily discount to the NAV in the supposedly the broadest
bond index ETF (AGG) in the business? You’ve got to be kidding me.  When it feels like you have no idea of what
you are looking at in the markets, my inclination is to just stay away.  Why would you use such a fund for safety when
you’ve got no idea what’s going on?  Put
it in an FDIC-insured savings account or a CD, maybe (zero paying) treasures.
But not in something that’s trading all over the place like a lot of the bond
ETFs are right now.

So the answer to Matt’s “Can you trust bond ETFs? ” question
would appear to be “no” right now. 

In the current scenario, my money would be on the
traditional fund structure that would actually have to liquidate the underlying
to cover redemptions (though determining NAV for small bond holders would seem
to be a similarly slippery proposition) than with the in-kind ETF structure…but
this would certainly be an interesting area to examine more closely.  Neither scenario is pretty is my guess, and
that’s worth looking at. How are the NAVs coming in on the large Vanguard funds,
for example. And if they’re giving the index NAV to redeemers, is that more
accurate or is it in effect the existing shareholders subsidizing poor index
pricing?

The most important point I want to make is that there is a
slight mischaracterization of the bond ETF situation by Murray in his article,
and Matt doesn’t really address it directly in his blog.  Murray mentions the possibility that maybe
these funds should be traded like closed end funds, and bought at a
discount.  The closed-end analogy is an
interesting one, but there’s a very big difference.

In closed-end funds, there is a known underlying with known
pricing, and the fund is trading at a premium or discount reflects investor
demand in the fund itself…as redemption for the actual underlying is
impossible.  In the ETFs, the underlying
index is not necessarily (I would say certainly is not in these cases)
reflecting the actual price of the underlying, and the ETF is effectively
serving as the price discovery mechanism for essentially unknowable
markets.  My money is generally going to
be with what the MARKET is saying on pricing.

So, in the case of these bond ETFs, my suspicion is that the
ETF is actually closer to the actual NAV (whatever that is) than the underlying
NAV price of the index is showing.  But
really, it feels a bit like walking around in the dark…but really, just like in
the Malaysia country iShare back in the day, the ETF is really the only game in
town as price discovery mechanism.  That
doesn’t say that it’s still not a bit of a blind guess as to what the value of
the bonds are. It’s really hard to know that, and that makes me nervous.

So I think that these ETFs are interesting and valuable as a
price discovery mechanism. But that doesn’t mean I’m putting my money there.   When I’m buying bonds, I’m buying a safe
haven, and if I have little idea of what’s going on, that to me is not a safe
haven.

The other interesting aspect to this story is the SEC
compliance issue with Barclays buying the Lehman indices (see Eric Rosenbaum’s
outstanding article discussing the situation). My understanding has been that
the SEC was unlikely to give BGI and exception allowing the same company to run
the indices that its ETFs are tracking because of potential conflict issues. I
don’t know if they’ll be able to work out some scenario where there’s a
firewall/separate entity.  Anyone who has
an update into the status of that, I’d be interested to hearing…we’ll certainly
be looking into that.

Last 5 posts by Jim Wiandt

• FINRA Warns On Leveraged ETFs - June 19th, 2009
• What is Wrong With Matt Hougan? - June 16th, 2009
• ProShares, Direxion Are NOT ETFs - June 16th, 2009
• Shock And Awe - June 12th, 2009
• ETFs Are A Scam? - June 10th, 2009