The Latest Exchange-Traded Fund to hit it Big

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It was only a matter of time. Before the crash, investors who wanted to buy more stocks jumped into exchange-traded funds at a record clip. Then bonds became the safe play, and ETFs with bond holdings jumped 61 percent this year, to $91 billion. But some analysts say this might be one area where the drawbacks of an ETF could outweigh its benefits.

Like a stock ETF, a fixed-income ETF holds a basket of securities ? in this case, bonds ? that track an index. Combine the solid returns bonds have provided recently with the ETF?s traditionally cheap fee structure and trading flexibility, and bond ETFs have nearly sold themselves. Yet unlike their stock-based cousins, a fixed-income ETF often trades at a premium, meaning the price of the ETF is higher than the value of all the bonds it holds.

In some cases, the premium is next to nothing. The premium for the iShares Barclays 1-3 Year Treasury Bond Fund was a minuscule 0.01 percent, on average, during the second quarter this year. But the premiums on municipal and high-yield bond ETFs can top 2 percent, more than the fee on an average bond mutual fund. Paying a premium means getting fewer assets for your cash, and ?you don?t want to start off in the hole,? says Morningstar ETF analyst John Gabriel.

Investors could wind up buying an ETF at a premium and then sell it at a discount, the equivalent of buying high and selling low. The premiums on bond ETFs reflect higher transaction costs, says Matthew Tucker, director of fixed-income investment strategy for Barclays Global Investors, a major ETF producer.

One rule of thumb: The broader the ETF, the lower the premium. So in a huge market such as Treasurys or mortgage-backed bonds, a fixed-income ETF likely could be cheaper to own than a corresponding bond index fund or mutual fund. But experts suggest that for more specialized markets, such as municipal bonds or high-yield debt, investors go with either a bond index fund or an actively managed bond fund, since the ETF premiums could eat away performance faster than annual fees on low-cost funds would.

A bond ETF, like all ETFs, also is limited in the number of assets it holds. Analysts say a bond fund could potentially buy more attractively valued bonds, while the bond ETF has to stick to the bonds it tracks in the index.

2009 Copyright The New York Times Syndicate