The Benefits of the ETF Structure
Many years ago, before the financial crisis, it was assumed that ETFs always traded at around NAV. The market volatility of 2008 and 2009 put paid to that. But the perception that ETFs should not trade at a significant premium or discount to NAV has persisted. In order to get a proper perspective on the issue, it is important to remember that ETFs are traded instruments. Consequently, any imbalance between supply and demand will invariably have repercussions for spreads and pricing.
What is important is that ETFs, unlike closed-end funds – which can trade at extremely sizeable discounts or premiums to NAV for long periods – have a readily available mechanism to minimize the impact of any disparities between supply and demand. While closed-end funds can issue new shares to reduce a premium or buy back shares to narrow a discount, this is a time-consuming process, usually at the manager’s discretion, or which requires specific authorization.
In contrast, ETFs have a highly dynamic real-time mechanism embedded in their structure that facilitates secondary market liquidity and minimizes the potential scale of any discount to NAV due to volatility in the underlying assets. As open-ended instruments, ETFs can create or redeem shares from inventory. Most importantly, this creation and redemption can occur automatically according to the needs of broker-dealers and with no specific authorizations required. During periods when demand for ETFs drops substantially, such as the second half of March, the authorized participant or market maker can still buy an ETF from an investor at a certain price and know that they can redeem it at NAV; that means they are still able to make the arbitrage spread, which for other product types may not be the case.
Why ETF Pricing is a Truer Reflection of Value
The NAV on an ETF is struck every night. In a liquid market, such as an equity index, it can be based largely on final trading prices. But in illiquid markets (like most bond markets) it is essentially an estimate of fair value based on the last traded price and assumptions about likely value given changes in market conditions and sentiment. Moreover, it produces a result that has a time lag – it reflects the previous day’s assumptions. To confirm this point, we looked at three different investment strategies2 within the ETF wrapper to see how they performed from March 9th to March 20th. The results showed that the market price was a leading indicator of where the ETF’s NAV would price the following day, providing a true reflection of value. When necessary, primary market ETF volume increased in concert with movements of the secondary market.