Bonds Bonds Bonds

While I don’t typically find articles about the bond market interesting, I do love a good ETF story. Most people are probably familiar with how the stock market works: you want to buy stock in company ABC so you go online or call your broker and say, “Please buy 100 shares of ABC stock.” Today, the stock market is basically e-bay but much more sophisticated and much, much faster (obviously an oversimplification).

However, when you want to buy a bond, it’s a lot harder. Mostly, because the bond market has vastly less liquidity. Meaning, millions of shares are not traded every second of the day. Most of the time, when you want to buy a bond, as an average investor you are limited to the inventory of the firm you work with. Most of the time, these aren’t the best bonds because the best bonds are kept by the companies that helped underwrite the bond offering itself or purchased by institutional investors with more buying power.

This is where bond ETFs come in. If you wanted exposure, to say, a “diversified portfolio” of bonds you would need to call your brokerage firm and spend a lot of time finding bonds in different industries, with different durations, and varying creditworthiness. It would be expensive, take a lot of time, and bore almost everyone involved. In the past, you could buy a bond fund (you still can!) but they trade overnight, have higher expenses than ETFs, etc., etc. Now, you can just go buy a bond ETF for a relatively low cost and sell it pretty much whenever you want. Of course, not many people realize that when you own an ETF with investments in it, somewhere is a large fund that owns all of the collective investments of the fund’s owners. When you sell a mutual fund or ETF, the cash you receive has to come from somewhere, either another investor or the investment company itself, depending on the market (this is another blog on to itself). For argument’s sake, assume the money is coming from the fund. You want your money back because you want to buy something else. Well, in order to pay you, the investment company needs to sell some investments inside the fund and, as we discussed, the bond market is not very liquid.

The good people at Goldman Sachs have found a way around this liquidity problem for its large clients who need to sell a lot of individual bonds. It can just sell them to ETF’s! Goldman is what’s called an “authorized participant,” meaning one of its many jobs is to supply ETF and mutual fund companies with the underlying securities in their funds through “credit portfolio trades.” Neat, right? So, a large client can call their broker and say, “I want to sell $5 million of my bonds” and instead of releasing those bonds out into the wild, Goldman can just sell them into an ETF. This is pretty good for large clients and mostly pretty good for ETFs, but not so great for the bond market as it sort of exacerbates the liquidity issue we talked about. It’s also kind of a problem when you consider that the liquidity issue is driving people to use ETFs in the first place. I often argue that in finance, technology serves to make everything more efficient. It doesn’t create new problems in the market but makes old problems worse.

Smart Beta

In the past, I have talked about my issue with smart beta: what has worked in the past will not necessarily work in the future (if only because those metrics were not being evaluated) and a lot of factor investing success has to do with being novel. When everyone trades a certain way, that performance becomes the standard for how to invest.

Anyway, quant funds, or smart beta, had its worst return in 8 years:

“Factor investing — which slices and dices equities based on traits like profitability and price volatility — has buckled while the broader market has stayed afloat. For example, AQR Capital Management LLC’s $1.9 billion mutual fund, one of the largest in the sector, last month nursed its steepest loss since inception.”

Particularly, value and momentum-based funds, which would conceptually move opposite each other, dropped in unison last month.

Also:

Half of ICOs Die Within Four Months After Token Sales Finalized

Ex-Heartland CEO Is Sued by SEC for Giving Deal Tip to Girlfriend

Where’s Your Raise? It Should Be Coming

Hedge Funds Don’t Want You Sharing Their Letters. Too Bad You’ve Got an iPhone.

What We Buy Can Be Used to Predict Our Politics, Race or Education — Sometimes with More Than 90 Percent Accuracy

Dreams of Goldman Doing Big Takeover Meet Stress Test’s Reality

Gainplan LLC is a Registered Investment Adviser. This blog is solely for informational purposes and not a solicitation to invest. Advisory services are only offered to clients or prospective clients where Gainplan LLC and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Gainplan LLC unless a client service agreement is in place. Please contact a financial advisory professional before making any investment.

Gainplan LLC provides links for your convenience to websites produced by other providers or industry related material. Accessing websites through links directs you away from our website. Gainplan LLC is not responsible for errors or omissions in the material on third party websites, and does not necessarily approve of or endorse the information provided. Users who gain access to third party websites may be subject to the copyright and other restrictions on use imposed by those providers and assume responsibility and risk from use of those websites.