Brendan Conway of Barron's breaks down the mechanics of how bond ETFs force shareholders to bear the cost of selling them in a falling market. Conway offers data from Goldman Sachs, showing ETF price volatility in good times and bad.

In 2012, Goldman strategists found that indexed corporate bonds, those owned by passive mutual funds and ETFs, tended to rise one percentage point faster each year in boom times and fall harder in selloffs, Conway wrote.

That should lead investors to be careful with municipal bond ETFs, high-yield and corporate ETFs as well as international equities, where stale prices reflect the time zone. A selloff in ETFs could affect how companies run those ETFs, such as dealers making risk-free profits by buying ETF shares at a discount in underlying assets and exchanging them for more expensive individual bonds, then selling them.

Here's the problem with that scenario, Conway wrote:

That activity is essential to ETFs' day-to-day success, since it serves to keep prices hewing close to the index. But there's a catch when markets get rough. When interacting with the ETF company, dealer firms can opt to get cash instead of an "in kind" redemption of the underlying bonds. Cash is a surer bet for the dealer, but a source of potential harm to the ETF shareholders.

To read more, click here.  

Edited by: Casey Quinlan


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