Until last week, exchange-traded fund giant Barclays Global Investors was the exclusive provider of bond ETFs, which is itself a narrow field. Just 14 of 432 listed ETFs at the end of February tracked a bond index, accounting for 5% of the $433 billion in total industry assets, according to the Investment Company Institute, a trade group.
Bonding with ETFs
Like Vanguard's stock ETFs, the new bond offerings are separate share classes of the company's existing index mutual funds.
The Vanguard Total Bond Market ETF, for example, tracks the same index as BGI's iShares Lehman Aggregate Bond Fund (
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99.67,
+0.08,
+0.1%) : the Lehman Brothers U.S. Aggregate Index. The three other Vanguard fixed-income ETFs track government and investment-grade corporate bonds of varying maturities.
The four Vanguard funds each have razor-thin expense ratios of 0.11%, making them the cheapest bond ETFs on the market.
Ken Volpert, a Vanguard senior portfolio manager, claims the ETFs benefit from being tied to the firm's large index funds. They will have considerably more holdings than the bond ETFs managed by Barclays, he said.
Vanguard Total Bond Market ETF holds 2,902 issues, according to Vanguard. The iShares Lehman Aggregate Bond Fund, in contrast, has 134 holdings, according to BGI.
Volpert said a higher number of bonds in the portfolio results in more diversification, better index tracking and lower default risk.
Vanguard's move has drawn criticism. In a commentary piece last week, MarketWatch contributor Mark Hulbert wondered why Vanguard even needed to introduce the bond ETFs. In particular, he questioned why investors would need to trade bond funds, citing the dismal record of newsletters that attempt to time the market.
According to Hulbert, "the main rationale for the new bond ETFs that they [Vanguard] are creating is to facilitate the kind of short-term trading that they used to discourage."
See full story. But for Vanguard, which has traditionally catered to do-it-yourself individual investors, the move appears related to distribution. In a late March interview, Martha Papariello, who heads up Vanguard's financial-adviser services unit, said ETFs provide a way for Vanguard to reach brokers and other intermediaries.
"ETFs give us a way to go and talk to firms we may not have had a relationship with in the past," Papariello said. "With ETFs, we're bringing index-based investment solutions to a market where we didn't historically have a large footprint."
Junk pile
Barclays last week unveiled the first ETF investing in junk bonds, which are more speculative securities rated below investment-grade. But along with extra credit- and default-risk comes the potential for more yield.
Matthew Tucker, head of fixed-income investment solutions at BGI's iShares, said the ETF may appeal to investors in or nearing retirement who are seeking income. High-yield bonds can also be used to diversify investment portfolios, he said.
The iShares iBoxx High Yield Corporate Bond Fund holds 50 issues and has an expense ratio of 0.5%. The fees on BGI's other bond ETFs for the most part range between 0.15% and 0.25%.
Tucker said the relatively higher 0.5% expense ratio for the new junk-bond ETF reflects that it's a "tougher product to manage" due to liquidity challenges in the high-yield market.
And while the iShares Lehman Aggregate Bond Fund has far fewer holdings than its Vanguard counterpart, the ETF appears to have done a decent job staying close to its benchmark. The fund, which has an expense ratio of 0.2%, has a three-year annualized return of 3.41%, trailing the tracking index by 0.28 percentage points, according to investment researcher Morningstar Inc.
"Barclays in 2006 had very good tracking error against the Lehman Aggregate despite the lower number of holdings," said Morgan Stanley analyst Paul Mazzilli. He said the main challenges in optimizing bond portfolios are getting the yield curve and credit quality right.
Competition
It appears last week's flurry of bond-ETF launches could be the prelude to a storm.
Ameristock Funds has filed regulatory documents to launch five fixed-income ETFs tracking Treasury indexes managed by Ryan ALM Inc. A firm called ETF Advisors had managed Treasury ETFs tied to Ryan indexes, but the funds were liquidated in 2003 due to lack of assets and trading volume.
Earlier this year, Morningstar introduced a family of investable bond indexes it said it wants to license for ETFs and other investment products. The Chicago investment research firm's stock indexes are already the benchmarks for several BGI ETFs.
Jim Wiandt, editor of industry publication Journal of Indexes, said Vanguard's entry into bond ETFs "changes the dynamics completely," and he expects more players such as ETF bigwig State Street Global Advisors to enter the field. He said the biggest gaps in fixed-income ETFs are municipal bonds and international and emerging market debt.
"Those will eventually come out, but it's surprising no one has pulled it off yet, despite the operational issues like [market makers] being able to hedge the portfolio, as well as liquidity and pricing challenges," Wiandt said, adding that profit margins are lower in bond ETFs compared to stocks.
"We're just earlier in the cycle on the bond side of ETFs," said Volpert at Vanguard. "Hopefully we won't see the proliferation into narrow indexes that we've seen on the equity side -- we want diversified core holdings for investors."
He said less-liquid areas like municipal bonds are "challenging," and that the company won't introduce an ETF unless it's properly diversified.
Tucker at BGI echoed the liquidity hurdles associated with munis and emerging markets, although he noted that the firm plans to expand its bond lineup. One difficulty, however, is that the ETF structure is geared to stocks rather than bonds, he said.
"Most providers have expertise in equities," he said, "It's tougher to understand fixed-income and capture the markets" in an ETF, although it's "inevitable more competitors will come into the space"
