They’re calling it the “ETF bid” — the idea that corporate bond prices get juiced when passively managed funds have to buy them. It’s known to happen in thinly traded stocks in some instances. So it shouldn’t come as a surprise that thinly traded, idiosyncratic markets like high-yield bonds are seeing a similar effect. It’s the cautionary part of an otherwise pretty encouraging story: ETFs’ power to crack open hard-to-reach asset classes for more investors.
This week’s print Barron’s ETF Focus on the subject concludes that investors should be especially wary of selling passively managed bond funds when markets turn bearish — that’s often the best time to buy. And investors who buy these ETFs when markets feel rosy pay a premium for the service. Obviously, it’s best to avoid paying extra if possible.
Yes, it’s the same old advice, to be a contrarian investor. But ETFs are only growing in importance in the bond markets. The more heavily they are traded, the more investors have to pay attention to their pricing dynamics — and that’s true even for those who don’t use ETFs. If you haven’t read our Barron’s print column, one of the key findings comes from Goldman Sachs’ (GS) Charles P. Himmelberg and Lotfi Karoui. The duo estimate that a monthly rebalanced portfolio of bonds tracked by the iBoxx $ Liquid Investment Grade Index, the benchmark driving the $24.5 billion iBoxx $ Investment Grade Corporate Bond Fund (LQD),has beaten comparable non-indexed bonds by roughly 4.7%, or about 1% a year, since the beginning of 2009.
Great, right? Well, not always. Index bonds also appear to sink harder during bad times, as they did late last year.
The popular exchange-traded note whose share issuance was capped last week by J.P. Morgan Chase (JPM) is already trading at a premium. Investors who hold the JPMorgan Alerian MLP Index exchange-traded note (AMJ) can either cash out now with unexpected profits or they can ride the note’s unusual mechanics higher in hopes of even bigger gains.
But the outcome behind Door #2 is unpredictable. Nobody wants to be holding the bag if JPM suddenly reopens new shares. J.P. Morgan hasn’t said whether it will take that step. But if it does, the investment’s premium, which resembles what you see in closed-end funds, would collapse in a hurry. That’s a risk that investors will bear if they stick with this tracker of rich-yielding master limited partnerships.
The crux of the issue is that AMJ is no longer just a bet on master limited partnerships. It’s also a bet on what other investors who hold or want to hold the same J.P. Morgan note will do.
At the moment, there’s a 45-cent premium in AMJ’s market price versus the underlying assets, or about 1.2%. It will get bigger if more investors pile in.
“This is a free gift. But how long do you watch the premium build before you sell the shares out? It’s a question that the owners of AMJ have to ask themselves,” Chris Hempstead, a director at WallachBeth Capital tells Barrons.com.
Actively managed exchange-traded funds attempt to pick winners much like, say, Bill Miller does in mutual funds. The number of such funds has taken off, and while they’ve tended to underperform versus passive index-tracking ETFs, they’ve also been less volatile.
Those are some of the findings of a new Lipper report by Sasha Franger, the company’s fiduciary research analyst. The group has returned an annualized 2.78% over the last four years, versus 3.20% for “pure” index peers, Franger found. The trend turned in the last year, however: Actively managed ETFs’ performance pulled ahead slightly.
Market gyrations appear to be blunted in actively managed ETFs. This makes intuitive sense: An active manager should be able to pull your assets out of plunging equities or bonds when the environment calls for it. Passive funds can’t.
Median active ETF annual performance ranged from 1.31% to 10.83% for the last four years, while median performance for pure index ETFs has experienced huge swings and has ranged from -40.09% to 55.59%, coinciding with the economic downturn and recovery.