Safety of Bond Mutual Funds v. Individual Bonds

Discussion of the Bond portion of the Permanent Portfolio

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Maddy
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Safety of Bond Mutual Funds v. Individual Bonds

Post by Maddy » Wed Mar 25, 2020 11:20 am

I was listening to a financial commentator (don't remember his name) who offered the opinion that bond mutual funds are extremely risky at this point in time. Had something to do with the fact that every investor can dump his shares at the click of a mouse, but that the fund itself cannot so easily get rid of its bond holdings. I do not pretend to understand any of this, but it perked up my ears.

What is the group's feeling about the safety of bond mutual funds (e.g., VUSTX)?
pmward
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Re: Safety of Bond Mutual Funds v. Individual Bonds

Post by pmward » Wed Mar 25, 2020 11:34 am

Yeah, bond mutual funds and ETF's basically broke last week (ETF's moreso than mutual funds). The Fed's announcement of becoming buyer of last resort in the secondary markets on Monday put guaranteed liquidity there. The risk wasn't just in funds and ETF's though, bonds themselves in the secondary market went no-bid at times last week. In other words, even in the U.S. treasury market, the so-called largest and most liquid market in the world, there were periods of time where if you needed to sell your bonds there was no buyer on the other end willing to buy them for any price. Bonds have been facing some pretty bad liquidity in the last couple weeks. But, now that the Fed is ensuring liquidity in the market, all should straighten out. The ETF's I've looked at have all went back to trading at NAV. Anytime there is a derivative (ETF, mutual fund, futures contract, option, etc) that is more liquid than the underlying these things can happen. Of course, you can also get hosed holding the individual assets if you need to sell and there is no buyer willing to buy them. There is no risk-free investment, especially in a liquidity crisis like we have been going through.
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Kbg
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Re: Safety of Bond Mutual Funds v. Individual Bonds

Post by Kbg » Wed Mar 25, 2020 7:11 pm

I would argue the complete opposite and I think the facts support my assertion. It was clear bond ETFs were providing the only pricing mechanism for most the bond market. Bond pricing completely broke down. The problem is the commercial bond market is one of the last Wall Street bastions of a fixed and controlled game. I'm almost certain after this event, structural changes are coming.

But to get at Maddy's point directly. In times like these it is really the perceived safety of the bond that matters most. In this kind of situation a bond is just a slightly less volatile stock...the focus, rightly so, goes straight to the ability of a company to pay its obligations. ETFs are just a lot of whatever kind of bonds they buy.
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Re: Safety of Bond Mutual Funds v. Individual Bonds

Post by Kevin K. » Sat Mar 28, 2020 7:18 pm

I'd appreciate feedback from any number of you here who are more knowledgeable about mutual funds vs. ETFs on this paragraph from Evanson Asset Management, a leading DFA FA firm.

I understand the point that it was lack of liquidity in the bond market itself that was the root cause of the problems over the past couple of weeks but it's concerning to me that ETF's did worse. Do these arguments make sense, and if so does that mean bond ETFs (including TLT which is typically said to be the only suitable vehicle for owning LTT's if you can't own individual bonds) is taking on unnecessary risk?

"EXCHANGE TRADED FUNDS (ETF's)

ETF's are legal and operational structures which differ substantially from open-ended mutual funds. DFA offers only open-ended funds while Vanguard offers both open-ended funds and ETF's. ETF's are created from pledged (promised) shares by authorized participants to ETF fund managers. ETF shareholders own a pledged asset, not a fractional share of an asset as is the case with open-ended mutual funds. It is a contractual pledge to provide the shares but does not provide true share ownership and during a market crisis contracted pledges could be abrogated. On countless occasions ETF's have traded at share prices far below the market value of the assets in the ETF, sometimes more than 60%. ETF investors do not own the pledged shares, the value of what they own is whatever the exchange traded shares trade for and that may be well above or below the actual market value of the underlying pledged securities in the ETF portfolio. ETF share owners own shares in a derivative structure though the ETF industry has argued ETF shares are not derivatives in the sense that futures and options are derivatives. This is technically true because futures and options derive their prices mathematically from the value of the underlying assets, not imprecisely from whatever the market will pay for an ETF pledge. ETF investors do not own an asset and the ETF does not own assets. That is the reason ETF's can have extremely low expense ratios, sometimes as low as 0.04%. Little more than a computer is required once they are legally set up and funded. Investors merely own a number based on a promise and contract. The ETF industry controlled about $5 trillion of assets as of Spring 2018.

ETF promoters have advanced the narrative that arbitrageurs will quickly close the spreads between traded share prices and the underlying value of the assets, the net asset value. And, ETF promoters emphasize that, unlike open ended mutual funds, ETF's allow intraday trading and instant liquidity with stops. However, a casual perusal of the historical share prices of ETF's versus their net asset value often reveals that ETF's have traded at very substantial discounts to the underlying pledged securities for periods of months or or even years. And, ETF's are heavily traded by high frequency trading computers in large amounts, trades which can change from buying into selling in nanoseconds. The examples below illustrate that ETF share prices can differ dramatically from the value of the pledged securities. In December 2014 the New York Federal Reserve Bank, Wall Street's top regulator, announced that extreme price movements in ETF's holding stocks, bonds and other assets had prompted it to take a closer look at the inner workings of ETF's. Little has been done as of 2019. The Fed was concerned that ETF share prices do not always reflect underlying securities values and that authorized participants who pledged the shares might not honor their pledges during periods of heavy redemption requests.

Risk in ETF's was dramatically illustrated in the so-called "flash crash" on May 6, 2010. The Dow fell almost 800 points in 25 minutes. The Wall Street Journal reported that while the Dow lost 9.2% of its value at its worst, many ETF shares lost almost all their value, some dropping to pennies per share. Stop losses triggered massive selling and due to the rules imposed by regulators, investors who lost between 10% and 60% were not compensated and had large losses. The Nasdaq canceled over 10,000 trades that took place more than 60% below the pre-crash price. When the damage was tallied about 70% of the canceled trades during the flash crash involved ETF's (CBS Marketwatch). The Wall Street Journal (10-10-10) also reported that hundreds of ETF's performed differently than the indexes they were supposed to track and had an average annual tracking error of 1.25% in 2009 and 2010.

On June 20th, 2013, a day where equity indexes declined substantially, the Financial Times reported, "The losses for ETF's today were far beyond what the most sophisticated financial risk models could have predicted for worst case scenarios". In August 2015 ETF declines were again serious and more than a fifth of all US ETF's were forced to stop trading. ETF liquidity disappeared instantly thanks to HFT computers. HFT ETF traders, however immediately blamed NYSE Rule 48 and pushed for its removal. Pressure to remove regulations on ETF's remains to this day. The Financial Times commented that HFT traders did not have enough information to run their algorithms, backed out of the market instantly and withdrew liquidity in August 2015. Trading was littered with more than 1000 trading halts that inhibited the alleged essential arbitrage mechanisms of ETF's and caused their prices to fall well below the indices they were designed to track. Futures, cash and ETF's are priced and arbitraged off each other and according to the Financial Times HFT showed "evidence of cracks in the plumbing that underlies the world's largest equity market." The Bank of England warned that "the risks associated with ETF's are not being made clear." Vanguard founder John Bogle has also warned about ETF's even though some Vanguard funds are ETF's. In 2016 (Financial Times, 12-13-16) he called for politicians to re-examine ETF's and noted that ETF investors trailed returns in conventional open-ended index mutual funds by a large 1.6% annually. He also complained that annual turnover in the largest ETF tracking the S&P 500 sometimes reached a stunning 3000% of assets, very significantly driving up trading costs. This was occurring even though the S&P committee doesn't change all that many securities when they meet to update the index periodically.

The Financial Times (7-25-13) reported that high levels of settlement failures in ETF's were reviving debates about their structure and liquidity. Settlement failures occur when banks pledge assets to ETF's and then fail to deliver them. The powerful Bank of International Settlements, the global central banker's bank, warned that settlement failures in ETF's pose potential systemic problems to the global financial system. Hint: Think 2008. Said one critic, "This is an unrealized risk which could morph into an operational risk in nanoseconds. What is the actual risk of a security if it takes five days to find the security to make settlement?" In May 2015 Reuters reported that the country's largest ETF providers were arranging billion dollar credit lines just in case an ETF sell-off turned into a credit market melt-down and they need to come up with money for shareholders since they won't be able to sell their pledged shares.

A Financial Times article on ETF's (4-24-18) states that ETF's are a "A $5T market that balances precariously on outdated rules" and "is a regulatory backwater" even though recent data shows that 7 of the 10 most actively traded US securities were ETF's. The article further states that ETF's create special risks and an ETF's price is only as good as the contracts that link everything together, collectively known as the "arbitrage mechanism". In times of stress this mechanism is fragile and has sometimes failed dramatically. According to the FT, the SEC largely improvises regulations for each ETF and existing disclosure rules fail to address potential problems with the arbitrage mechanism. Functionally identical funds are often subject to disparate rules or opaque rules. For example, The US's second largest ETF that tracks the S&P 500 lost 20% on 8-24-15 even though the S&P 500 that the index is suposed to track lost only 5%.

It should also be noted that one common narrative for promoting ETF's is that they don't pass through yearly capital gains to investors. This is so since investors don't actually own shares, they own a number representing shares. Although DFA does pass-through capital gains in its funds, DFA's capital gains pass-throughs typically are very low, running in the 0% to 2% range annually in most funds though volatile markets and smaller illiquid foreign markets can increase capital gains and increase pass throughs. DFA's tax-advantaged core-vector funds are so tax efficient that they sometimes pass through no gains in a given year. Indexes tend to be somewhat less tax efficient than DFA style passive asset class funds since they are reconstituted every 6 or 12 months but still are far more tax efficient than actively managed funds that trade frequently.

To summarize, ETF's create many risks which do not exist in open-ended mutual funds, particularly a liquidity risk, and most ETF's are based on indexes which have their own inherent costs and flaws described above. Evanson Asset Management® does not recommend ETF fund structures or indexes though if our clients wish advice on selecting them and purchasing them we will do so."
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Re: Safety of Bond Mutual Funds v. Individual Bonds

Post by pmward » Sat Mar 28, 2020 8:58 pm

Kevin K. wrote:
Sat Mar 28, 2020 7:18 pm

I understand the point that it was lack of liquidity in the bond market itself that was the root cause of the problems over the past couple of weeks but it's concerning to me that ETF's did worse. Do these arguments make sense, and if so does that mean bond ETFs (including TLT which is typically said to be the only suitable vehicle for owning LTT's if you can't own individual bonds) is taking on unnecessary risk?
A couple things. First, the risk was only real for anyone that sold the week before last. At that point TLT was trading below NAV. It only took a week of bond ETF's trading below NAV before the Fed stepped in as buyer of last resort and the situation then resolved pretty much instantly. Anyone that bought below NAV the week prior got a nice little bonus. Anyone that held through it and did not sell was unaffected. An ETF is not going to permanently trade below NAV, and it will only have this happen in a liquidity crisis. So what was the risk here? That you would lose a couple percent if you had to sell. What was the risk of individual bonds? They went no bid. So if you held individual treasuries you could not have sold them if you needed the money that week. Which was worse? Having to pay a little extra if you need the liquidity, or not being able to access the liquidity if you need it? Also, seeing as how the Fed instantly fixed the issue, and they know how to fix it again in the future, I think the odds of a long term move from NAV in ETF's are low. Mutual funds did get impacted as well, but not as much as ETF's for a few reasons. Mutual funds do not have intraday stress to contend with, mutual funds know in advance how much is being redeemed that day, and mutual funds do not have short term traders, algorithmic traders, and hedge funds trading them short term based on nothing more than volatility. At the end of the day, there are tradeoffs to each way you can own bonds. But ETF's definitely had their weaknesses exposed in this fiasco. For long term holds I'm more inclined to go with Fidelity's long term treasury fund or individual bonds vs ETF's.

Also, do keep in mind that while it was bonds this time, these things can happen with any asset where the fund is more liquid than the underlying. You can add commodities, REIT's, small cap stocks, micro-cap stocks, emerging market stocks, etc as well to the list. Matter of fact the junior miners ETF GDXJ last week also went below NAV by a large margin. There doesn't always have to be someone on the other side willing to buy. In a liquidity crisis you find that out real quick. The people that normally arbitrage markets stop when there are no buyers they can sell to.
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Re: Safety of Bond Mutual Funds v. Individual Bonds

Post by Kbg » Sat Mar 28, 2020 10:46 pm

Don't confuse pricing with asset ownership. If you buy an ETF or a Mutual Fund they both represent a pool of assets which are owned by the sponsoring company. You own mutual fund shares or ETF shares, the sponsoring company owns the assets. If you have a good broker you can check what the underlying ETF's NAV is at that moment. Additionally, ETFs have to post their holdings daily, meanwhile mutual funds only have to do so quarterly.

If one wanted to flip the article on it's head the title could have been "Mutual Funds Lack Transparency During Market Stress"

Anytime you have an intermediary between you and the "thing" there is more risk. In today's world not having an intermediary of some kind is almost impossible. Even if you hold stock direct, you've still got the broker who is actually holding the stock.

If you stick to large (as in AUM) ETFs you will be fine but pricing can get disconnected...as it can for anything. I'm going to guess by the end of the days noted there wasn't a whole lot of difference between mutual fund and etf prices for equivalent funds.

If you are looking for safety I would stay with really large "too big to fail" type of investment firms who are heavily regulated. Schwab, Fidelity, Vanguard, iShares. I think I would think more about this than ETF vs. Mutual Fund.

Mutual Funds and those who sell them as part of their business model are getting their lunches eaten by ETFs so they take every opportunity to pick at them.

All the above does not apply to ETNs or exotic ETFs that employ swaps and derivatives...but in the later case the issue isn't really the wrapper it is the potential danger of the underlying assets.
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Re: Safety of Bond Mutual Funds v. Individual Bonds

Post by Kevin K. » Sat Mar 28, 2020 11:26 pm

Thanks very much pmward and Kbg! I appreciate your taking the time to reply and what you’re saying makes complete sense.
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