[Editor’s Note: This was originally published on our sister site IU.com]
The difference between index tracking and premiums/discounts is key to understanding how ETFs work.
The past week has spurred a lot of discussion around ETF volatility since the posting of a Bloomberg article on July 11 claiming that, in extreme market conditions, ETFs exhibit higher volatility than their indexes compared to mutual funds.
A day later, Dave Nadig responded with a blog analysing the article’s claims.
But I also think it’s imperative that ETF investors understand the difference between index tracking and premiums/discounts. Understanding these two factors is key to understanding how ETFs work.
Distinguishing between the two is important here because comparing ETF share prices with mutual fund net asset values (NAVs) isn’t exactly an apples-to-apples comparison.
In the Bloomberg article, it seems the distinction between tracking and premiums/discounts was somewhat lost.
I say this because the article clearly states Bloomberg’s analysis didn’t measure premiums/discounts. But in the paragraph before that statement, it literally said that they calculated the degree of daily price variation using the ETFs’ closing prices vs. their benchmarks.
The difference between tracking versus premiums/discounts can be a tricky concept to grasp, especially for investors used to buying mutual funds. Still, as more investors shift to ETFs, it is, as I said, imperative to know the difference.
Regarding tracking error, there are different ways to measure it. Generally, it measures the variability of the fund’s NAV relative to the index it tracks. In a more simplified form, tracking difference simply compares the returns of the fund’s NAV with index returns over a specific period of time.
Slippage in tracking can come from different factors, such as expense ratios and the degree of sampling (optimisation).
Meanwhile, premiums and discounts measure how far the market price of the ETF veers off from its NAV.
This is where things get interesting, and what the article hammered on about. Unlike mutual funds, since ETFs trade intraday, market forces can temporarily push the ETF price above or below its NAV.
Dave explained the reasons for these dislocations already, so I won’t reiterate his points.
But one thing I want to highlight is that for international funds, including emerging market ETFs, what complicates the matter is that local markets where underlying securities are traded are often closed during U.S. market hours.
So, clearly, there could be temporary dislocations between stale NAVs—and stale index values—versus fund share prices, as news is disseminated during US market hours and market expectations change.
But these discrepancies tend to be short-lived, and fund prices often quickly revert back to NAVs for most funds because of the ETF’s creation/redemption mechanism. Therefore, these price dislocations are mostly just short-term noise for long-term investors. (The exceptions are a few funds that target hard-to-access markets like Vietnam or Chinese A-shares.)
Also, since ETFs are traded like stocks, bid/ask spreads come into play. Spreads tend to widen during extreme market conditions because it creates uncertainty in the underlying securities’ share prices, and hedging costs for market makers can increase.
That doesn’t suggest that the functionality of ETFs is flawed. It’s simply the nature of the ETF structure, and it’s a price investors have to pay for the ability to trade the ETF during market hours.
With regard to mutual funds, the article also implies that mutual funds are less volatile. Perhaps that’s because mutual funds price once a day after the close and investors get “NAV.”
Still, it’s important to understand how NAV is computed. Practically all international mutual funds have to fair-value their NAV, meaning investors don’t know exactly what price they’re going to get when they put in their order before the close.
Take mutual funds targeting Japan, for example.
There’s zero overlap in market hours between the Tokyo Stock Exchange (TSE) and the New York Stock Exchange. Let’s say that during US market hours, Fed Chairman Bernanke makes an unexpected comment regarding stimulus that propels the U.S. markets higher.
Do you really think an investor who puts in a buy order for a Japan mutual fund before the close of U.S. market hours will get the NAV based on the previous night’s closing prices on the TSE, knowing full well that stocks in Tokyo are likely to gap higher on the open in Asia the next day?
Most of us only wish it were that easy to make money.
At the end of the day, as a mutual fund investor, you really have no idea where you’re going to get filled.
At least when you trade an ETF, you know exactly what price you’re getting, and where the fund is trading relative to the closing NAV (or index value). You’re in control of what price you’re paying if you do the homework.
When it comes to tracking, mutual funds are not immune either.
The Bloomberg piece specifically talked about discrepancies that could arise due to the manager’s inability to exactly replicate the index (not to mention the exorbitant fees that many mutual funds charge).
At the end of the day, yes, fund prices for certain ETFs—like those targeting emerging markets—can temporarily deviate from their NAVs during U.S. market hours during volatile market conditions. But again, this more or less affects short-term investors or traders.
It comes down to this: If you need to trade during turbulent times, pay careful attention to spreads.
For investors with a long time horizon, understanding that deviations from stale NAV or index values— often the result of non-overlapping market hours—tend to be temporary for the majority of funds could help eliminate confusion.
The beauty of ETFs is that they can be beneficial for short-term and long-term investors.
The increased transparency and the ability to trade intraday just gives investors more control, but just as important, requires them or their advisors to be responsible for understanding the finer points of having all this control.