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Posted by on Mar 1, 2010 in AdvisorShares, ETF Education

The Pricing in ETFs Works Better

The Pricing in ETFs Works Better

There is a story in today’s WSJ regarding Bond ETFs.  The story suggests that the nature of corporate bonds in an ETF means that ETF buyers (and sellers) may be subject to excessive premiums and discounts.  I think it is important for investors to have a clear understanding of the difference between bond “mutual funds” and bond ETFs.  There are two important things to correct in the story.  First, there is a quote from Matt Hougan who states “the corporate bond market is notoriously illiquid”.  It’s not exactly correct to label the corporate bond market illiquid, as much as it would be more correct to say that bonds do not trade as frequently as equities.  Many bonds are easily liquid, but just don’t trade that often – there is a big difference.  While the last price on a bond, might not reflect its current value, the ability to get out of a position is usually fairly easy (not for all corporate bonds of course).

The next thing that is important to note is a quote from an advisor “Investors aren’t making the investment they thought they were,” Mr. Levy said. “They want the underlying securities, not the buy-sell value of the market.”  Mr. Levy’s firm avoids bond ETFs, choosing instead bond mutual funds, where shares are always priced at NAV.

Except the fact that many bond ETFs don’t price at “NAV” they price at “fair value”.  Read the fine print of the prospectus, and you will find that the Fund can use a process to come up with a price that is more reflective of the price of the underlying bonds than the last traded price of the bond is representing.

So while the story is correct, bond ETFs do trade at premiums and discounts, ultimately what they are trading at is the fair market value.  So you have two choices, you can buy and sell bond ETFs where the true value is determined by many buyers and sellers in the market, or you can buy a bond mutual fund where the NAV is also fair valued and priced by a pricing committee that you may not know much about.  I would pick the ETF.

Then add on the fact that you can set limit orders to get in or out of the ETF – it makes investing in ETFs a far better option (all other things being equal).

While it is not surprising that there needs to be more education in the ETF space, it is surprising to see that more education is needed on mutual funds as well.