How ICE's "Fair Value Pricing" is Helping Bond ETFs Reduce Tracking Error

Why it matters for bond ETFs

Bond ETFs, despite democratizing access to bonds by trading on exchanges, face a tracking error challenge due to differences in trading venues between ETFs (exchange-traded) and bonds (over the counter).

ICE identified a key dynamic contributing to this discrepancy, which can be explained in four steps:

1. Bond market holidays and early closes are advised by SIFMA, while equity market schedules are set by exchanges.
2. Annually, there are about 5-6 days when the bond market closes early but equity markets remain open until 4 p.m., reducing bond trading activity after 1 p.m.
3. ICE observed that bond ETFs show increased tracking error on these days, particularly in December, when tracking errors are higher on early close days.
4. This discrepancy arises because bond ETFs typically use a 1 p.m. ET price snapshot. On days like the year's last trading day, when market volatility spikes after 1 p.m., this methodology impacts fixed income ETFs that continue trading until the equity market's 4 p.m. close.

How ICE's "Fair Value Pricing" fixes this

ICE's "Fair Value Pricing" utilizes regression, a statistical method to estimate the relationships among variables. It's akin to predicting your final grade in a class based on hours studied. If historical data shows that more study hours lead to higher grades, regression helps predict your likely grade based on your study hours.

ICE applies this concept by analyzing how certain financial instruments (like Treasury futures) historically move and using that to estimate how bond prices should adjust between 1 p.m. and 4 p.m., when the bond market might be closed but equities continue to trade. The results?

• The iShares US Investment Grade ETF (USIG) saw a reduction in tracking error by 0.13% on December 29, 2023, aligning index pricing with ETF net asset value and enhancing accuracy.
• The iShares 20+ Year Treasury Bond ETF (TLT) experienced a more significant tracking error reduction, by about 0.40% on the same day.

The takeaway for investors? If you're keen on managing your fixed income allocation closely, it's worth paying attention to the index provider behind your ETFs. Some, like ICE, are continually innovating to deliver better results for the end investor.

By leveraging advanced methodologies like "Fair Value Pricing," they aim to reduce tracking errors and align ETF performance more closely with the underlying index. So, as you consider your fixed income strategy, take a moment to explore ETFs benchmarked against indices that prioritize accuracy and investor outcomes, like those offered by ICE.

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.