Do You Believe In Bond ETFs?

That was a great blog you wrote about how to choose ETFs, Paul. But there’s one big question you didn’t address: Should you buy an ETF in the first place?

In case anyone missed it, Paul’s blog is a must-read . It offers a superb checklist for the kinds of things investors should consider when they’re choosing among different ETFs.

But is an ETF always the most appropriate vehicle for accessing the asset class you’re trying to invest in?

You touch on this when you discussed whether investors should buy an ETF or a comparable low-cost mutual fund. But I mean it in a different way, and specifically as regards one asset class in particular: fixed income.

In the U.S., there are a number of advisers who believe that ETFs are a bad mousetrap for fixed-income exposure. The thinking breaks down along two lines:

  1. The fixed-income market is illiquid and disjointed, and there is an obvious and immediate opportunity for active managers to add value.
  2. The fixed-income market is too illiquid to support ETFs. Because it’s difficult to buy and sell the underlying bonds, it is difficult to create and redeem shares of a fixed-income ETF. As a result, the funds often trade at large premiums or discounts to net asset value. Furthermore, the funds may not accurately track the broader fixed-income market because they must track heavily optimized portfolios.

I’m wondering what you think about both point 1 and point 2. Do you think active management makes sense in the bond space? Does it have a better shot than in equities?

And on point 2: Does that apply in the European market? Or does the swap-based nature of most ETFs obviate concerns about illiquid underlying components?

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