Saturday, June 22, 2013

ETFs were trading at discounts this week following the sell-off. Is this a problem?

Many exchange traded funds (ETFs) traded below their fair value this week following the global sell-off triggered by worries the Federal Reserve will pull back on monetary easing, the Financial Times reported. Discounts widened sharply as dealers had trouble keeping up with a flood of sell orders.

Emerging market ETFs were particularly affected as shares of iShares MSCI Emerging Markets (NYSE: EEM) traded at a 6.5% discount to net asset value. The EEM discount dropped to about 1% by the end of the week. Some bond ETFs also traded at steeper than normal discounts during the week, but by Friday they also were priced closer to fair value.

Exchange-traded funds are similar to mutual funds except you can trade them intraday like stocks. They've become extremely popular in recent years because they are an inexpensive way to gain exposure to a diverse array of asset classes, including US stocks, international stocks, bonds and commodities.

How does an ETF trade at a discount? The net asset value (NAV) of an ETF is calculated by dividing the total value of all the securities in its portfolio by the number of its shares outstanding. The market price of the ETF is determined by the forces of supply and demand. At times and for various reasons, the market price of an ETF can deviate from its NAV.

An ETF is said to be trading at a discount when its market price is lower than its NAV—if you are buying the ETF, this is good news because you will be paying less than the value of its holdings; however, if you were selling this week, you received less than NAV. Is this bad? No, the market self-corrects. Authorized participants (APs)—usually institutional investors that have entered into a contractual relationship with the ETF to create and redeem shares—play an important role in the efficient pricing of ETFs. Through a market mechanism called arbitrage trading, APs help keep ETFs trading at a price close to their NAV.

Simply put, when ETFs trade at a price above NAV on the exchange, APs can step in and buy large blocks of ETF shares at the NAV by exchanging the underlying representative securities in a transfer-in-kind transaction called a creation. APs can then sell these ETF shares at a risk-free profit, essentially pocketing the spread between the NAV and the market price. The reverse happens when an ETF trades at a price below NAV.

This sort of arbitrage trading demonstrates why ETF market prices above or below NAV are self-correcting. Large-enough deviations from NAV create profit opportunities for APs, and as they conduct arbitrage trades, an ETF's market price becomes more closely aligned with its NAV. For example, in the case of an ETF that trades at a premium, APs selling newly created ETF shares increases the supply in the market, which helps drive down the price of the ETF closer to its NAV. Therefore, if you are a longer-term investor, you have little to worry about ETFs selling temporarily above or below their NAV.  So is there a problem and is this a major story? No. It happens every time there is a huge sell-off in the markets. 

By the end of the week the price difference had eroded  As the table below shows, the average discount to NAV for the 1436 U.S. ETFs as of the closing on 6/21/2013 was -0.25%. The table below shows the average discount by broad ETF category. The data was obtained from Morningstar Direct.

It needs to be noted that some ETFs (i.e. municipal bonds) tend to be quite small and have limited trading volume - and will experience more variation from their NAV than larger ETFs - and tend to trade at a large average discount.   

In summary, the ETFs trading at larger than normal discounts during the sell-off on Wednesday and Thursday was not a problem.... unless you absolutely had to liquidity your ETFs during that period.