Dave Nadig over at Index Universe has a really good post this week about the pricing of exchange traded funds with respect to their net asset values.
There is, after all, a tendency for the market to take the daily NAV valuations spluttered out by ETF providers as gospel.
In actual fact, as Nadig points out, each provider — and even each individual ETF — abides by its own often unique valuation methodology. More often than not, though, it’s focused on the cost of liquidating the fund at the current bid price.
As Nadig explains (our emphasis):
NAVs aren’t a magical fair market value, as much as that would be useful. In the bond space, as the chart shows, it’s based on the bid price of every bond in the portfolio, a literal “what would I get if I had to dump all these bonds?” But every fund has its own way of calculating NAV, and often, it’s even a bit vague what that is. Here’s how, for example, the United States Oil Fund (NYSEArca: USO) says it comes up with NAV: ETF holdings are “… valued by the Administrator, using rates and points received from client-approved third-party vendors (such as Reuters and WM Company) and advisor quotes.” Have fun reverse-engineering that.
So how can an investor really be sure that an ETF’s end of day valuation — against which premium and discount deviations are set — is a fair assessment of the fund?
Nadig refers to the following two charts from an article by Matthew Tucker and Stephen Laipplto to make his point:
The first shows the pricing as it might occur in a perfectly balanced market and in which NAV is determined by the portfolio bid price — i.e. what it might cost to liquidate the fund. Despite the equality, however, the graph shows to what extent the value of an ETF’s holding remains fuzzy. And that’s because it is determined largely by the liquidity of the underlying securities. If liquidity is scarce then the discrepancy between the bids and offers can be quite large.
Nevertheless, in a balanced market ETFs generally trade in a much tighter band than their underlying holdings might suggest a) due to the exchange-traded nature of the shares and b) because authorised participants only ever deal in a much smaller portions of the underlying, known as baskets.
The cost of replicating a basket is naturally much cheaper than the cost of replicating an entire fund, as is the cost of liquidating a basket versus an entire fund.
As Nadig says:
It’s really one of the only free lunches in investment management history. OK, not entirely free, as you’ll pay some basis points over time to own an ETF, but from a trading perspective, ETFs in illiquid markets like high-yield bonds have made some very fine purses out of smelly pig parts day in and day out for years.
So what happens when the price of an ETF hits a discount or premium in the secondary market?
Well, the second chart shows exactly how these dynamics playout.
As Nadig explains:
Here, we actually break the blue band of the ETF out of the theoretical “right” prices for the portfolio holdings themselves, giving us a window on the real market. After all, if the authorized participants and arbitrageurs really believed the prices in the gray band, they’d never let the ETF drop out of line. Instead, that white zone becomes a representation of the true, fair market value of actually unloading the securities based on the opinions of those participants. The ETF, in a sense, becomes the “better” market.
So from an authorised participant’s point of view, because the NAV is the fund’s entire bid price — or what it might cost, in the worst case scenario, to liquidate the fund — not only is the ETF providing security baskets at a much cheaper price than its NAV, the authorised participants are most likely able to capture an even better spread than what the NAV actually implies.
Which makes APs much more likely to intervene in a discounted ETF than one that carries a premium — because a premium would have to surpass the NAV way beyond the cost of replicating underlying for an arbitrage trade to make sense.
Related links:
Creating liquidity out of illiquidity – FT Alphaville
Understanding Bond ETF Premiums And Discounts – Index Universe
How ETFs fueled high frequency trading - FT Alphaville