InvestmentPersonal Finance

Exchange Traded Funds – A Fair Weather Friend

By August 11, 2014 No Comments

Exchange traded funds allow you to buy and sell units in managed funds on the ASX, just like regular shares. While this can be convenient, there’s nothing inherently superior about ETFs vs. regular open-ended funds – it’s just a wrapper. It’s what’s inside that counts.

Some ETFs offer lower fees than their open-ended counterparts, presumably because the fund manager has been able to outsource their unit-registry operations to the ASX clearing house. Nonetheless the mechanics of how ETFs operate warrants closer examination.

Unlike an open-ended fund,  ETFs trade throughout the day at a discount or premium relative to the net asset value (NAV) of the underlying shares. In most, cases the spread between the two is negligible because shares are created and liquidated by independent agents, or “authorised participants” (AP), who buy up the securities underlying the funds and bundle them into ETF shares that are delivered to the fund company. The same process works in reverse to liquidate ETF shares.

Any disparity between the ETF price and the underlying bundle of shares presents an arbitrage opportunity for authorised participants to pounce on, capturing a risk-free profit. In normal market conditions, this activity keeps the ETF share price and net asset value in close alignment.

But what happens in a crisis?

The mechanism works well with stocks, which are highly liquid, but not with bonds, which are not. During a “credit-event”, liquidity becomes very thin on the ground and most corporate bonds trade only “by appointment”. The whole AP mechanism breaks down, often at considerable disadvantage to the shareholder. The open-end fund holder by contrast (who can always buy and sell at the 4pm NAV), has no such problem.

One of the primary roles of bonds in your portfolio is to act as a buffer during a market downturn. They should retain their value in a crisis, not just to soften the fall in value of your portfolio, but critically to provide some dry-powder to buy risky assets at low prices. As witnessed during the GFC, bond ETFs can fail you when you need them most.

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