Keep iNAV; Encourage ETF Transparency

I don’t often disagree with Matt and Dave, so it saddens me to do it publicly—but iNAV isn’t the problem. You’re both throwing out the baby with the bath water.

Matt made some great points in his most recent blog, as did Dave in his.

Yes, it’s true: iNAV is not perfect by many measures. It’s susceptible to mispricings in an ETF’s underlying basket—for international ETFs it’s a stale value, and for fixed-income ETFs, there’s no question the thing is a shadow of the true value.

Still, that doesn’t mean you throw the thing out completely.

Let’s step back for a second and look and what we’re discussing—ETFs.

These are products that trade intra-day. Unlike their mutual fund counterparts that are priced and invested just once a day, ETFs are designed to be liquid assets, and anytime you have a liquid asset, you need a point of reference to properly value that asset.

Really, there are two problems here that should be addressed: iNAV is long overdue for a proper upgrade. Secondly, investors need to start treating ETFs as ETFs—not as stocks, or mutual funds.

iNAV Upgrade

iNAV does a great job when it comes to US equity ETFs, but even then it suffers from key issues that need to be addressed in an upgrade.

An ETF can be bought and sold faster than a click of a mouse. Not that I encourage such high-frequency trading behavior, but iNAV does need to reflect the times. The 15-second interval in ETF pricing that currently prevails should be replaced in favor of one-second updates.

If anything, the “flash crash” of May 6, 2010 is a testament to how the current securities-trading infrastructure can become unhinged in a matter seconds, and investors should be properly armed in their ability to assess the market. Publishing snapshots of iNAV in one-second intervals would surely help.

Secondly, iNAV needs to be specialized based on the underlying portfolio of the ETF in question. The calculation for US equity ETFs is rather simple because the underlying securities trade during US market hours.

But, crucially, that methodology has to be adjusted once you move outside that space.

Fixed-income, international-equity and commodity-based ETFs should be treated differently not only in their calculation, but with the proxies used to value the portions of the basket that aren’t liquid or trading.

Really, regulators and issuers should work on providing the investing public with fair-valued iNAV quotes—a service provided by few firms, but one that isn’t nearly as common as it should be.

To be fair, fair-valued iNAV quotes make assumptions that might not be realized in the underlying basket. But they still provide a solid reference point for investors.

The dissemination of these values is also a huge issue. It’s ridiculous to consistently note stale values on Google finance or Yahoo finance, and no one should have to spend around $15,000 (€11,500) to access a Bloomberg terminal for these values. The simple truth is that they should regularly update on ETF issuers’ websites.

Investors And ETF Trading

At the center of this whole debate, we have to remember exactly why Matt and Dave felt it necessary to take a stance in the first place.

It all stemmed from a terribly misinformed article from the Financial Times about how ETFs can sometimes trade at premiums and discounts to their NAVs.

As much as I can harp on the FT for such poor reporting, I won’t, because it only highlights the greater issue at hand—many investors still have yet to understand how to trade ETFs and analyze the trading of ETFs.

My biggest pet peeve is when I hear someone say, “An ETF trades just like a stock.” Although this is the most common line used when explaining ETFs, it couldn’t be further from the truth—especially when you’re trying to understand ETF liquidity and how to trade ETFs.

iNAV may be flawed in some respects, but even if it were perfect, many investors simply don’t understand how to properly use it.

At the end of the day, an ETF isn’t a closed-end fund; it isn’t a mutual fund; nor is it a stock.

Sure, it contains some elements of each of these structures, but an ETF’s liquidity is governed by many factors, including the liquidity of the fund’s underlying portfolio, the hedge-ability of that portfolio, the creation/redemption policies of the issuers, who the lead market maker is, etc.—I could go on and on. But you no doubt get my point: There are many factors to consider.

Unfortunately, many investors treat ETFs like stocks: “I need to purchase an ETF now, so I’ll use a market order”; or “I’m interested in using liquidity as a filter, so I’ll use the bid/ask spread to determine what I can buy.”

All—and I do mean all—of these assumptions are wrong.

Let’s Take An Example

Take the trading that happened in the YieldShares High Income ETF (NYSEArca: YYY) on Friday, June 21. At 9:39am on the fund’s launch date last Friday, someone bought 100 shares at $33.20.

It’s unclear if it was a market order, but seeing that the quote prior to that execution was an offer for 300 shares at $33.25, it’s not too crazy to assume that the buyer simply bought the market—or what they thought was the true market.

Frankly, this sort of trading error occurs on a daily basis, and I’ve mentioned it countless times in blogs.

The funny thing about the YYY trade is that iNAV was a better reflection of the true price. Even when investors have the right tools in front of them, one thing still rings true: In many cases, investors are their own worst enemies.

This situation also highlights why iNAV is crucial for investors: You can’t simply rely on the price discovery of the ETF’s share price to reflect the actual value of the ETF.

This is especially true for illiquid ETFs and ETFs that don’t enjoy competitive quoting from market makers.

We can sit here and criticize iNAV all we want, but the truth is, investors need it. More importantly, investors need to be better educated. Eventually, someone will realize the opportunity in properly guiding them.

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