Bond exchange traded funds (ETFs) are gaining ground rapidly. Investors are finding the low costs of bond ETFs attractive because even relatively small fees cut dramatically into the low returns found in today’s fixed-income markets. For example, Vanguard Total Bond Market ETF (Ticker: BND) lets investors buy a portfolio of more than 3,000 U.S. investment-grade bonds with one trade. It has an expense ratio of 0.11%, much lower than comparable mutual funds.
Fixed-income ETFs are considerably more difficult to operate than a stock ETF. The underlying problem is that bonds are much less liquid than stocks traded on established exchanges. For example, the Barclays Capital Aggregate Bond Index, the most commonly known bond index, includes more than 8,000 bonds, many of which do not regularly trade. Because of this, ETF sponsors rely on representative sampling to approximate the index returns they are supposed to follow. This causes the bond ETFs to experience tracking errors with their chosen index, thus undermining one of the reasons for investing in an ETF in the first place.
According to Morningstar, the fixed-income ETFs now total more than $180 billion. This is still considerably smaller than the $2.5 trillion in fixed-income mutual funds. Nevertheless, the dramatic growth in bond ETFs are a significant trend. As bond ETFs get larger, the additional holdings allow the ETF sponsors to more closely approximate their indexes, thus reducing the challenge noted in the preceding paragraph.