The only thing worse than no information is bad information, and for most ETFs, iNAVs are downright misleading. They should be banned.
The intraday net asset value, or iNAV—also known as the indicative optimized portfolio value (IOPV), indicative intraday value (IIV) or intraday portfolio value (IPV)—is a number born of the best intentions.
By law and by practice, ETF providers are generally required to publish an iNAV every 15 (or 60) seconds of every trading day for every ETF they offer. The Securities and Exchange Commission explained in a recent release:
The iNAV is intended to approximate the fair value of the securities held in the portfolio by the ETF and should closely represent the value of the fund during the trading day.
That sounds great; unfortunately, it isn’t remotely true for at least half of the ETFs on offer.
This became a flash point recently thanks to the flurry of incredibly bad financial journalism surrounding ETF trading activity last week. Good reporters at reputable news outlets like the Financial Times took that SEC definition at face value and wrote sentences like:
ETFs track baskets of underlying assets, such as emerging-market stocks or municipal bonds, but discounts widened sharply on Thursday as dealers struggled to keep up with the sell orders … For example, the share price of the iShares MSCI Emerging Markets Index fell to a 6.5 per cent discount to the underlying asset value.
That sounds scary. But as anyone with a solid understanding of how ETFs work knows, that statement is effectively meaningless.
Let’s see why.
Domestic Equity ETFs
Let’s take the one example of where iNAVs work exceptionally well: domestic equity ETFs.
Imagine an extraordinarily simple ETF like the iShares S&P 500 ETF (NYSEArca: IVV). IVV’s investment mandate is simple: Hold all the stocks in the S&P 500 Index, in the exact proportions of the index.
Each morning, iShares publishes what’s known as the “creation basket” for IVV. This is the list of securities that an authorized participant must purchase and deliver to iShares to “create” more shares of the fund. This basket is generally identical to the securities that the fund wants to hold, which are, of course, all of the securities in the S&P 500 Index.
As a condition of getting the exemptive relief it needs from the SEC to run the fund in the first place, iShares must list with an exchange that will publish an iNAV every 15 seconds of every trading day. A third-party calculation agent does this, and the work is extraordinarily simple: Take all the securities in the ETF, look at the last price they traded at, add it all up, divide by the number of shares outstanding, and calculate the iNAV.
This offers a real-time view of the fair value of IVV, and one would expect IVV to trade in line with its iNAV almost all of the time. In fact, it does.
This is great system: Investors get a real-time view of fair value, so they know if they are over- or underpaying for IVV when they push “buy.”
International Equity ETFs
Unfortunately, this all breaks down once you move beyond US equities. Let’s take, for example, the iShares Hong Kong ETF (NYSEArca: EWH). It tracks large and midcap stocks trading in Hong Kong.
The problem is that Hong Kong’s market isn’t open during US market hours. Being on the other side of the world, the Hong Kong Stock Exchange opens at 9:30pm ET, and closes at 4am ET. So how do you calculate the iNAV at 11am ET?
The same way you do with IVV. You take EWH’s creation basket, multiply each holding by the last price at which it traded and adjust for currency movements.
By now you see the problem: Because the underlying shares are closed during US market hours, their prices don’t change. As a result, the iNAV hardly moves!
So what happens if, at 1pm ET, Fed Chairman Ben Bernanke says he’s raising interest rates 2 percent? The market will tank, and everything—including EWH—will trade lower.
But EWH’s iNAV will not move, because the underlying securities are not trading. If you were to look at EWH and compare it with its iNAV, it will look like it’s trading at a discount. But it’s just reacting to Ben’s statement, just like everybody else.
This lies at the heart of the FT’s confusion. It looked at EEM and saw it trading at a “discount” and figured that the ETF market was broken. In fact, everything in the world was trading down; EEM’s iNAV was just frozen in time, with just a handful of stocks trading in markets like Brazil providing any real feedback. Most of its holdings are in markets that were closed.
That, in a nutshell, is the problem. For international ETFs—and, indeed, for most fixed-income and commodity ETFs—iNAVs are beyond useless. They are misleading.
Why does it matter? Not because the FT gets its reporting wrong or because people worry about the ETF market being broken. It matters because investors can get hurt.
What if you saw EEM trading at a discount last week and said, “Oh boy—a discount. I’m going to buy every share I can so I can profit when it rebounded?”
What if you saw it trading at a premium and said, “Oh boy—a premium. I’m going to cash out!”
What if you sat on the sidelines, frozen in confusion, because none of it made sense?
The requirements that ETF issuers publish iNAVs trace back to the days when the only ETFs that existed covered US stocks. With ETFs covering every asset class in the world, we’ve gotten to the point where most iNAVs are simply misleading. They should be banned for all ETFs where the underlying doesn’t trade during US market hours.
Regulations are supposed to help people, not hurt them.
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