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The Hidden Costs of Corporate Bond ETFs

The Hidden Costs of Corporate Bond ETFs

Posted October 14, 2022 at 10:15 am
Quantpedia

Excerpt

Exchange-traded funds (ETFs) have been recently booming in popularity and enjoy great praise for their flexibility and accessibility in terms of liquidity. They allow investors convenient exposure to less liquid assets such as corporate bonds. But liquid ETF instrument based on illiquid assets is a recipe for a lot of hidden problems (and sometimes disasters), especially in such a turbulent period on fixed income markets as it’s now.

There are various certain specifics which come with creation of new ETFs and problems for buying of underling prospects to match the fund’s NAV. Chris Reilly’s paper (2022) revolves around the point that ETF managers encourage Authorized Participants (APs) to more aggressively arbitrage tracking errors to the benefit of ETF investors while simultaneously allowing APs to interact strategically with ETF portfolios at the expense of ETF investors. The author found that delivered bonds do not underperform because ETFs hold low-risk or high-liquidity subsets of underlying benchmarks and receive lower compensation for their lower risk. But instead, ETF holdings shift in the time series, and ETFs increase holdings in bonds when the short-term future return on those bonds. But why is that?

Consistent with APs learning from the order flow of their informed customers, dealer inventories increase in the 5 days before a bond is delivered into an ETF portfolio. On the day a bond is delivered to ETF portfolios, dealer inventories instead fall, consistent with APs simultaneously seeking to reduce their inventories through their market-making activities and via ETF share creations. It is taken that ETF investors are aware of the hidden cost, and the magnitude of the cost reveals a high willingness to pay for the liquidity transformation provided by corporate bond ETFs despite the hidden cost being high.

Underlying asset liquidity is a first-order determinant of optimal security design for ETFs. While these ETFs do underperform their benchmark by greater than their stated net expense ratios (as much as claimed 48 bps p.a.), they still offer a liquid alternative for investors that do not have the resources to manage their own fixed income portfolio. This summary could be taken as a good reminder that investors’ expenses to obtain liquidity in the fixed income space are often quite substantial.

Author: Christopher Reilly

Title: The Hidden Cost of Corporate Bond ETFs

Linkhttps://papers.ssrn.com/sol3/papers.cfm?abstract_id=4147882

Abstract:

I document a hidden but substantial cost associated with the liquidity transformation that corporate bond exchange-traded funds (ETFs) provide. When creating new shares, authorized participants (APs) deliver a subset of the portfolio of bonds that underlie a corporate bond ETF. This subset contains bonds that realize low future returns, reducing ETF performance by 48 basis points per annum. This loss in performance cannot be attributed to forgone compensation for risk or illiquidity, but instead results from APs utilizing information regarding future changes in bond values to strategically deliver bonds when those bonds are expected to realize poor performance in the near future.

Visit Quantpedia for additional insight on this topic: https://quantpedia.com/the-hidden-costs-of-corporate-bond-etfs/.

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Disclosure: ETFs

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