Rick Ferri on Corporate Bond ETFs vs. Funds

I found the following article particularly interesting, and given "dumbstruck"'s posting this morning about market versus limit orders, it seemed related enough that others might also find it interesting. Ferri's work is always a pleasure to read.
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Why We don't Buy Corporate Bond ETFs
Corporate bond ETFs don't work for our clients. Large price discounts and premiums to net asset value (NAV) tend to occur when we are trading. These deviations from NAV can add unnecessary trading cost to portfolios. Accordingly, we're believers in traditional corporate bond mutual funds that trade at NAV at the end of the day.
The size of the ETF NAV/MktPx discounts that Ferri demonstrates were actually surprising to me. I've been generally pretty happy with the performance of LQD (the iShares iBoxx $ Investment Grade Corporate Bond ETF) - transparency of holdings, a good index, very low costs, plenty of liquidity in the ETF. As liquid as the holdings in LQD are, the discount it displayed was surprising, though not surprisingly, a lot smaller than the corresponding spread for the high-yield ETF, HYG.
I'd be very interested to see how Vanguard's unique ETF-as-a-share-class affects this. Vanguard's got both open-end shares as well as ETF shares of their Intermediate-Term Corporate Bond Index - VCIT and the institutional share open-ended class shares VICBX (theoretically the min. invst is $5million, but there may be ways around that).
Morningstar suggests that VCIT, LQD, CFT and CORP are all direct competitors. LQD is by very far the largest and most liquid, at over $16billion in assets. VCIT (and the corresponding institutional shares all together) has about $0.9billion, CFT has about a billion and CORP, by far the smallest of the group, is only about $75million.
Anyway, Ferri's article is well worth the read.
There may be some closed-end funds worth looking at in this area, too, since CEFs have the advantage of not having to create or redeem shares, they don't get hit by liquidity/trading issues the same way open-ended or ETFs might. On the flip side, though, CEFs often have (a) high management fees; (b) leverage; and (c) discounts/premiums to NAV are sometimes erratic, though (c) may also present some opportunities when discounts are wider than usual for a given CEF. I generally stay away from CEFs due to (a) and (b) (and general aversion to actively managed funds in the first place).
David S. Meyers, CFP(R)
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David S Meyers CFP

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Ferri's problem is that he wants to do things backwards: buy bond ETFs when they are at a premium to NAV and sell bond ETFs when they are at a discount to NAV.
Normal people can do it the normal way: buy bond ETFs when they are at a discount to NAV and sell bond ETFs when they are at a premium to NAV.
Make the bond ETFs premium/discount to NAV work for you and the problem is solved.
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There are a few bond ETFs that I keep an eye on where the discount/premium spread runs over 3% in either direction. Not every quarter, but often enough that it's something to check on. And in general, trading spreads are pretty wide.
Note though that depending on the bond ETF you're talking about, there can also be uncertainty about NAV itself. Some bonds just don't trade that often, and to the extent the ETF holds those it introduces some uncertainty in the NAV of the ETF. So it's rational for the spreads to be wide and there to be persistent discounts/premiums.
CEFs have a much bigger issue in this regard, they have much higher liquidity/trading issues than ETFs which at least have an arbitrage mechanism to keep their pricing somewhat in line. With CEFs you can add in a layer of premium/discount variability that is larger than the two- or three-year yield of the underlying bonds. Heck, 6-7+ years in one case. Who are the investors currently buying certain Gross-ly overpriced bond CEFs? Even assuming some NAV uncertainty, it makes no sense.
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Tad Borek

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