A bond ETF is designed to track a given index of bonds. The ETF then, ideally, purchases these bonds and trades at the value of these underlying assets throughout the trading day. An ETF is like a mutual fund in the way it holds a portfolio of securities. However, it is different from a mutual fund because it trades like a security. An investor does not need to buy into the fund; instead, he or she can purchase the ETF at any point during the trading day and sell the ETF at any point.
Benchmark vs. Index
When an ETF is listed for exchange, it is listed based on a benchmark of bonds it anticipates purchasing. This group of bonds will include some constant growth bonds and some value bonds, which are priced below what the fund managers believe to be the actual value of the bond. These bonds are the true "deals" on the market, and they will hopefully represent a large profit stream if the manager's estimates are correct. Unfortunately, the ETF has not always purchased these bonds when the benchmark is created. At times, they cannot get a hold of the bonds, so the benchmark may grow in a given day when the ETF's actual index has not grown at all.
Difficulty Purchasing Bonds
The reason an ETF may have trouble purchasing a bond is because of the lack of central exchange for bond trades. When there is a central exchange, the exchange sets a price and then matches buyers and sellers wishing to trade at that price. With the lack of this system, there is no matching, and buyers and sellers often have large disparities in their desires for pricing. The result is an inconsistent market where some bonds will not trade at all for days at a time. So, when an ETF goes in to purchase the value bonds it desires, the fund may not be able to find any of the bonds for sale at that price. The fund will have to wait, even though the benchmark indicates the bond was already purchased, and the fund will not capitalize on any profits during this waiting period.
With any fund, transaction costs can quickly chip away at profits. Some investors prefer to work with passively managed accounts for this reason. The less transactions made on a daily basis, the lower the transaction costs, and the higher the potential profits from well-managed funds. Because of the complications of the bond market, it can be even costlier to buy and sell bonds than other types of securities. Add to this the fact that actual profits do not always match expected profits, and you can be looking at a net loss even when the investor anticipated a healthy gain. Investors dive into the bond market when the economy is rocky, thinking bonds are the safest investments available. However, the combination of these unpredictable factors often make bond ETFs much costlier and riskier than most investors understand when they purchase the funds.