By Lewis Braham

Actively managed bond exchange-traded funds are more popular than their stock counterparts. Yet they have a major flaw: Many of them trade at a premium that effectively makes them much pricier than they first appear.

Fixed-income ETFs have been gaining popularity as investors seek to buffer their volatile stockholdings. Currently, there is some $311 billion invested in active taxable bond ETFs, versus $282 billion in active U.S. stock ETFs.

A recent report by Morningstar found that both active and passive ETFs generally trade at premiums to their underlying portfolio value, or net asset value $(NAV)$, but that premium was significantly greater for active bond ETFs.

Premiums are an additional cost of ETF ownership versus mutual funds, which are priced at NAV. One of ETFs' big selling points is their lower expense ratios, but with premiums, investors' total cost actually could be higher. Another big ETF positive is greater tax efficiency, but that's largely irrelevant to investors seeking income from taxable bonds.

"I do not think that there's as much of a case for putting bonds in an ETF as there is for putting stocks in an ETF," says Morningstar research analyst Lan Tran, who wrote the report, "Watch Your Step With Active Bond ETFs." "A lot of your taxable distribution comes from interest income, which is the same between bond ETFs and mutual funds either way."

This isn't to say the ETF structure can't be advantageous. Tran points out that certain types of bond ETFs trade at greater premiums than others. Generally speaking, the more illiquid the bond type and the longer the maturity of the bonds an ETF owns, the greater the premium distortion will be.

In Tran's report, ultrashort bond ETFs, investing in highly liquid debt, traded at a median premium of only 0.05 percentage point if actively managed, versus 0.02 point if indexed. Those are largely negligible amounts, given the cost savings ETFs have over mutual funds and the advantage active bond managers tend to have over indexes.

But the median active corporate bond, high-yield bond, nontraditional bond, and intermediate core-plus ETFs had percentage-point premiums of 0.21, 0.19, 0.21, and 0.13, respectively. These are significant increases. The largest active intermediate core-plus category ETF, the $18.5 billion Fidelity Total Bond (ticker: FBND), has an expense ratio of 0.36%. The similar $38.9 billion Fidelity Total Bond mutual fund (FTBFX) has a 0.44% expense ratio. But if you end up paying a 0.13-point premium for the ETF, your costs are higher than the mutual fund. (Further complicating matters, you would pay no transaction cost to buy the mutual fund at brokers Fidelity and E*Trade, but $74.95 at Charles Schwab.)

There are strategies to produce better outcomes. One is to buy and hold the ETF, as the premium cost only occurs at the point of purchase and diminishes over time; a 0.20-point premium is only 0.04 point additional cost per year over five years. The other is to place limit orders specifying the price you will pay at the times of purchase and sale and pay close attention to the premiums you're paying.

If you're an active trader, you can mitigate the premium cost by making sure that when you sell an ETF, it trades at the same or greater premium than you originally paid to buy it, thus neutralizing the upfront cost.

Still, even these strategies have wrinkles. Consider that many long-term investors like to reinvest their fund distributions automatically. Brokers will automatically buy more of the ETF shares at whatever the current premium is with each distribution, adding to your cost. And traders often like to sell securities during periods of market stress. That's when bond ETFs tend to trade at discounts to NAV, so you overpay on the way in and get paid less than you should on the way out.

The active bond ETF remains an imperfect vehicle.

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April 09, 2025 02:00 ET (06:00 GMT)

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