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July 22, 2013 01:00 AM

Volatile markets put spotlight on mechanics of ETFs

Ari I. Weinberg
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    Mark Wiedman: “More and more, ETFs are becoming the true market.”

    Proponents of exchange-traded funds laud the flexibility of the ETF structure when it comes to investment strategies, but some less-communicated realities of ETFs still surprise investors when they rise to the surface during market volatility.

    In a stressed market, long-term investors may not need to consider the core mechanics of an ETF unless they willingly choose to transact. During that time, they could find significant premiums or discounts of the ETF price to various representations of underlying value. These gaps tend to normalize when a market clears.

    At the same time, for critical players in daily ETF liquidity — short-term traders, arbitrageurs and market-makers — the shifting price and availability of underlying assets are very real and the costs to hedge exposure can change at a moment's notice, often dramatically, forcing aberrations from typical trading spreads, premiums/discounts to net asset value and even squelch the availability of cash redemptions.

    Over the last two months, secondary market investors sold rate-sensitive ETFs (and traditional funds) with longer durations en masse as 10-year Treasury rates rose to as high as 2.7% from 1.6%. According to IndexUniverse, ETFs with underlying duration above 3.5 years shed $10 billion in assets in the second quarter.

    In less liquid areas of the bond market — high-yield corporate, emerging market and municipal securities — the selling pushed many ETF prices to atypical discounts to their closing NAV, the set price at which creations and redemptions with the fund are executed. Indeed, the move also led some to question the validity of indicated optimized portfolio value, published throughout the day to give an indication of fair value of an ETF.

    These dislocations in late May and early June prompted iShares, a unit of New York-based BlackRock Inc., to disseminate an open letter to investors on June 29. In the letter, Mark Wiedman, global head of iShares, offered up a contentious declaration: “More and more, ETFs are becoming the true market.”

    The letter was a response to criticism — not directed only at iShares — that ETFs were breaking and failing to deliver on their stated goals of replicating an underlying index. But Mr. Wiedman's letter continued: “In a rapidly moving market, the reported prices of individual underlying assets may become stale. The ETF price can become the true price for that market, and the underlying assets may eventually catch up with any gap between the two.”

    “Premiums and discounts offer a real expectation for the value of the fund,” says Chris Hempstead, head of ETF execution services at New York-based broker WallachBeth Capital LLC. “When trading spreads blow out in stressed markets, they hit thinly traded asset classes first and the ETF goes in to price discovery mode.”

    Mr. Hempstead says that trading spreads widened in ETFs tracking emerging market debt and high-yield securities, for example, which was probably unsettling to investors comfortable with the prior spread range. “In volatile markets, the bid represents fair value,” he says.

    Leading price discovery

    Jim Ross, senior managing director and global head of SPDR ETFs at State Street Global Advisors in Boston, points to previous times when ETFs led price discovery for closed markets or less-liquid securities. “After 9/11, many stocks in the U.S. didn't open because market makers didn't have a two-sided market.” The SPDR S&P 500 ETF was able to open and “stocks, as they opened, came down right in line,” to value represented by the ETF price, says Mr. Ross.

    More recently, ETFs holding short-term commercial paper and corporate debt helped guide those markets in the fall of 2008. But, for a fund itself to drive price discovery, it would have to buy or sell the underlying assets — which is traditionally not the function of an ETF.

    Wholesale creations and redemptions of ETF shares are generally handled in-kind, to the extent that the underlying securities are easily transferrable. Funds do offer the option of cash creations/redemptions, assessing a variable charge to the authorized participant to compensate the fund for transaction costs and market impact. But, in order to provide the maximum protection for the remaining fund investors, cash redemptions can be suppressed or restricted when market impact would have a significantly adverse effect on the fund.

    “The rules aren't changing midstream,” says Dave Nadig, president for ETF Analytics at researcher IndexUniverse. “In most ETF prospectuses, there's actually a tremendous amount of flexibility available to the issuer or custodian. If you don't know this, you're not reading the instructions.”

    For investors trying to keep track, historical premiums and discounts to closing NAV are provided by the ETF sponsors. Index values and IOPVs also have their own tickers for intraday comparisons. n

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