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ETF Education
ETFs Branch Out
| The skinny on bond ETFs. |
| by Christopher J. Traulsen, 07/30/02 |
| Daytrade Bond Funds, Now! |
| Actually, don't. Trading bond funds in an effort to capture intraday price movements is about the dumbest idea we can think of (except for, perhaps, the media's obsession with fund flows, and leveraged Internet funds). It is, however, at least possible to do it with the launch of a raft of new bond ETFs from Barclays Global Investors last week. Also on the way are bond ETFs from Gary Gastineau's ETF Advisors and a slew of leveraged and short index ETFs from ProFunds (Vanguard also just launched three ETFs tracking emerging markets, Pacific, and European indices). |
| Breeding like Rabbits |
| If it's summer, it must be time for more iShares. Barclays Global Investors, the company behind iShares and (not coincidentally) the world's biggest indexer, let fly with 39 ETFs in the summer of 2000 and seven last summer. Not yet having pummeled quite all investors into submission, the firm launched a barrage of four bond-index ETFs this week, including three Treasury ETFs of varying durations and one that owns Treasuries and government agency credits. The firm also has in the works an additional Treasury ETF and another focusing on corporate bonds. Not be outdone, ETF Advisors will fire its own volley of four bond ETFs, the unfortunately named FITRs, at an as yet undetermined date in the future. |
| There's a relative paucity of decent, inexpensive bond-index funds out there, and these give investors yet another viable choice. We like them for that. However, they come with a few significant caveats. For one, the ability to trade them intraday seems pointless. For another, the usual advantage ETFs have with regard to taxes won't be of much use with bonds. Almost all of the tax pain with bond funds comes from income distributions, not capital gains. While ETFs are able to reduce their capital-gains distributions in ways that mutual funds cannot, they'll churn out the same amount of taxable income as mutual funds tracking the same bond indices. |
| Total Costs Matter |
| There's also the issue of costs. We hate to sound like a broken record, but don't--DO NOT--simply look at their annual expense ratios and conclude bond ETFs are cheaper than bond-index mutual funds. The iShares offerings do offer attractively low annual expense ratios of 0.15% per year. That's truly a pittance, and well below the charges levied by bond index funds from Vanguard, the king of low-cost mutual funds. But unlike no-load mutual funds, you have to pay trading commissions to buy and sell ETFs. If you're investing a lump sum for a relatively long period of time, ETFs may well be a cheaper way to go. However, if you're dollar-cost averaging, the trading commissions you pay can easily overwhelm any amount paid in annual fees. |
| To take a small example, say that you wish to invest $10,000 in a bond fund for three years, and plan to liquidate your investment at the end of the period. You might select Vanguard Intermediate-Term U.S. Treasury fund VFITX, which charges 0.28% per year, or you could g o with iShares Lehman 7-10 Years Treasury Bond fund, which charges just 0.15% per year. At the end of three years, assuming a 7% return, the Vanguard offering would have cost you $96.04, and the iShares fund would have run you just $65.74, including the cost of a round-trip trade at $8 per transaction. In this case, the ETF is easily the least expensive choice. |
| On the flip side, consider what happens if you put $1,000 a month in a bond fund for one year. If you use Vanguard Intermediate-Term U.S. Treasury, you'll pay $19.28 in fees, again assuming a 7% return. But if you use the iShares offering, you'll pay $121.90, including $96 in commissions (assuming the same 7% return and a low commission rate of $8 per trade). In this instance, ETFs are clearly the more expensive way to go (You can calculate and compare the costs of using different funds and ETFs in your own investment program with our nifty Cost Analyzer tool.) |
| Market-Timers Rejoice? |
| ProFunds, a shop that caters to market timers with mutual funds that offer leveraged long and short exposure to various indices, is jumping on the ETF bandwagon. That isn't too surprising: Since investors can buy ETFs on margin or sell them short--essentially creating their own custom index exposures instead of being forced to accept those designed by ProFunds--the firm is facing a serious competitive threat. Better yet for the timing crowd served by ProFunds, ETFs offer continuous intraday pricing. |
| The firm has registered nine ETFs all together, four offering 200% exposure to the S&P 500, Nasdaq 100, Dow, and S&P 400 mid-cap indices, and four that offer 200% inverse exposure to the same indices. Of course, investors could create a similar effect using existing ETFs. Expense ratios for the ProFunds ETFs have not yet been disclosed by the firm. It should go without saying, but we'll say it just in case: We think these are phenomenally bad ideas. |
