One of the characteristics that is supposed to differentiate exchange-traded funds—and other exchange-traded products, such as exchange-traded notes (ETNs)—from closed-end funds is better pricing. A closed-end fund, which does not alter its share count except for rare secondary offerings, often trades at a premium or discount to the net underlying value of its assets (aka net asset value). ETFs, in contrast, are open-ended funds. They constantly issue and redeem shares. This process is intended to limit any pricing discrepancies. In other words, when you buy an ETF, you are supposed to get the return of the assets the fund in invests in.
This is often not the case. I looked at the difference in 12-month market and net asset value returns for over 1,600 ETFs. (I’ll use the abbreviation ETF to refer to all exchange-traded products, including ETNs.) The market return for nearly one out of five ETFs (19.4%) was more than a full percentage point different than the return of the fund’s underlying net assets for the 12-month period ended June 30, 2016. Worse yet, the difference was greater than five percentage points for 39 funds. Not a 5% difference, but a full five percentage points of difference (e.g., DB Gold Double Long ETN (DGP) had a 12-month market return of 25.7% and a NAV return of 20.7% through June 30, 2016).
I’ll explain the terminology and some of the more common characteristics of the offenders in a moment. Before I do, I want to point out that not every ETF succumbs to the pricing error. Slightly more than 500 funds—representing nearly a third of all ETFs with 12-month return data—either had market returns that matched their net asset value or were within 0.1 percentage points of it. Investors who owned these funds got the returns of the underlying assets.
Net asset value (NAV) is what a fund’s assets are worth. The net asset value of a fund holding 100 stocks and a relatively small amount of cash will be the current portfolio-weighted value of those 100 stocks plus the cash. Mutual funds trade at NAV because shareholder purchases and sells are made at the end of the day. This process allows the mutual fund companies to determine the prices at which shareholder transactions will occur based on the end-of-day value of the underlying assets.
ETF prices, in contrast, change in real time throughout the trading day. Unlike mutual funds, which are bought from and sold back to the mutual fund company, ETFs are bought from and sold to other investors on the open market. Only authorized participants (large trading firms, market makers, large financial institutions, etc.) directly transact with the ETF provider. Authorized participants exchange creation units (generally blocks of 50,000 shares), a basket of securities mimicking the creation unit or, in some cases, the equivalent value in cash with the ETF provider. This process is intended to wring out pricing efficiencies by giving authorized participants the ability to take advantage of any premiums or discounts to NAV that arise.
Because we individual investors buy and sell ETFs on the open market, we realize the market return. The market return is the change in an ETF’s share price plus any distributions paid to shareholders. The net asset return, in contrast, is the return realized by the fund’s underlying assets. As stated above, there was either no difference or just very little difference between the 12-month market and NAV return for 504 ETFs. These ETFs tended to be the large funds with median assets of $467 million. Four of the largest ETFs —SPDR S&P 500 ETF (SPY) , iShares Core S&P 500 (IVV), Vanguard Total Stock Market ETF (VTI) and Vanguard 500 ETF (VOO) —all closely track their NAV. iShares MSCI EAFE's (EFA) market return was 0.7 percentage points different than its NAV return. (I calculated the median instead of the average total assets to avoid having the largest ETFs skew the number upwards.)
The 319 ETFs whose market returns were more than a full percentage point different than their net asset value were considerably smaller. Their median total assets were $10.0 million, far below the median $98.3 million for all ETFs with 12-month returns. They also traded less frequently, with a median average daily trading volume of 10,000 shares versus 98,300 for all ETFs with 12-month returns. Roughly two-thirds were open-ended funds (what most people think ETFs as being) and not debt instruments (ETNs), unit investment trusts or partnerships. Several international stock and international bond funds as well as many leveraged funds made the list. The biggest commonalities, however, were a small asset size and low trading volume.
For those of you who are curious, the worst offender was iPath® Short Enhanced MSCI Emerging Markets ETN (EMSA)which had a 12-month market return of 67.8% and a 12-month NAV return of 27.0%. The largest ETFs by total assets to make the list were iShares MSCI Emerging Markets (EEM), iShares iBoxx $ High Yield Corporate Bond (HYG) and iShares Silver Trust (SLV) .
The Week Ahead
Just 25 members of the S&P 500 will report. The only Dow Jones industrial average component will be Walt Disney Co.(DIS), which will report on Tuesday.
The week’s first financial report will be second-quarter productivity, released on Tuesday. Wednesday will feature the June Job Openings and Labor Turnover Survey (JOLTS). July import and export prices will be released on Thursday. Friday will feature July retail sales, the July Producer Price Index (PPI), June business inventories and the University of Michigan’s preliminary August consumer sentiment survey.
The Treasury Department will auction $24 billion of three-year notes on Tuesday, $23 billion of 10-year notes on Wednesday and $15 billion of 30-year bonds on Thursday.
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