The Hidden Premium in Active Bond ETFs: Are You Paying Too Much?

Actively managed bond exchange-traded funds (ETFs) have seen a surge in popularity as investors seek to navigate uncertain fixed-income markets. Currently, hundreds of billions of dollars are invested in taxable active bond ETFs, rivaling the assets held in active U.S. equity ETFs. However, a less discussed aspect of these investment vehicles is the potential for investors to pay a premium over the underlying value of the ETF's holdings, effectively increasing their cost of ownership. 

 

While both active and passive ETFs can trade at a premium or discount to their net asset value (NAV), research indicates that active bond ETFs exhibit significantly larger and more persistent premiums. This premium represents an additional expense for ETF investors compared to mutual funds, which are typically priced at NAV.

 

One of the touted benefits of ETFs is their lower expense ratios compared to traditional mutual funds. However, the presence of a substantial premium can erode this advantage, potentially making the total cost of owning an active bond ETF higher than a comparable mutual fund. Furthermore, while ETFs are often lauded for their tax efficiency, this advantage is less pronounced for investors seeking income from taxable bonds, as the taxable distributions from active interest remain similar in both ETF and mutual fund structures. As noted in previous discussions, the compelling reasons for holding bonds in an ETF structure might not be as strong as for equities.

 

The magnitude of the premium can vary depending on the characteristics of the bond ETF. Generally, ETFs holding less liquid bond types and those with longer average maturities tend to experience greater premium distortions [i]. For instance, active ETFs focusing on corporate bonds, high-yield bonds, nontraditional bonds, and intermediate core-plus bonds have shown median premiums of notable levels. Consider the Fidelity Total Bond ETF (FBND), a significant player in the intermediate core-plus category. While its expense ratio might be attractive, any premium paid on top effectively increases the overall cost to the investor, potentially exceeding that of a similar mutual fund with a slightly higher expense ratio.

 

Despite this hidden cost, investors can consider certain strategies. A buy-and-hold approach can mitigate the impact of the initial premium over time. Additionally, using limit orders when buying and selling can help investors control the price they pay or receive, allowing them to be more mindful of prevailing premiums or discounts. Active traders might also aim to offset the initial premium by ensuring they sell the ETF at a comparable or higher premium.

However, these strategies have limitations. Many long-term investors favor automatic reinvestment of fund distributions. This process often leads to the purchase of additional ETF shares at the prevailing premium, compounding the cost over time [i]. Moreover, investors often seek to sell fixed-income assets during periods of market stress. It is precisely during these times that bond ETFs can trade at a discount to their NAV, creating a scenario where investors buy high (with a premium) and sell low (at a discount).

 

While active bond ETFs offer potential benefits through dynamic portfolio management, investors must be vigilant about the hidden cost of premiums. This factor can diminish the allure of lower expense ratios and warrants a careful comparison with traditional mutual funds, particularly for long-term investors and those who automatically reinvest distributions. Paying close attention to premiums at the time of purchase and sale, and considering strategies like buy-and-hold or limit orders, can help investors navigate this often-overlooked aspect of active bond ETF investing. Investors should always consider all costs associated with an investment, including any premium paid over NAV. Remember that all ETFs are subject to risk, including possible loss of principal, and funds concentrating on a single sector typically exhibit higher volatility.