The Cleverness of the ETF is Underestimated...and how a "bad" ETF can actually be good.
In my regular discussions with users and sponsors of ETFs, they struggle with the empirical and structural relationship between ETFs and their assets, and they often miss the fundamental (and intentional) differences built into the ETF form. As ETFs seek to do more with their assets and their structure, I think it’s important to break with the limiting logic that ETF pricing is merely a fund accounting exercise.
For clarity, I do not mean to suggest that ETF NAVs should be disregarded – NAVs do create an anchoring point around which trading prices will occur. What I do argue is that the ETF (as an instrument) is different from its constituent parts, and that the processes around pricing, trading, creating, and redeeming ETFs is as much an exercise in financial replication as it is fund accounting.
ETF Shares Trade and Most Other Fund Shares Do Not (Trade)
In a traditional mutual fund (and many other fund types), every fund share transaction is a primary transaction, and every primary transaction triggers asset “buys” or “sells”; the per share value (or NAV) in non-ETFs is an accounting exercise over the observable prices of the underlying assets. In contrast, most ETF share transactions do not trigger a transaction over the assets, but rather they occur in the secondary market away from the fund. Further, market makers (high frequency and others) devote time and resources to facilitate and profit from flows in ETF shares - not just as an exercise to indirectly trade the underlyings, but as market making in a semi-autonomous instrument in a separate market.
In practice, the majority of market makers are not flying in and out of creation baskets, but rather they usually remain flat, trade proxy hedges, or rely on sophisticated in-house risk systems which aggregate open market positions across individual traders. For clarity, material increases in buying or selling pressures will initiate creations or redemptions, but generally only when the secondary market dynamics have played out.
The ETF Bundle and Valuation
Unique to much of the fund world, ETFs deliver continuous prices, unique liquidity, unique access, and extraordinary convenience. This bundle of attributes, and the relative bargain price at which they’re delivered, is worthy of Amazon.com (and SSGA, and BlackRock, and Vanguard,....). While continuous ETF prices may look like a latent and perfunctory exercise in fund accounting, they are really much more.
Much of the coverage, commentary and blogging around the ETF industry is focused on “performance” as measured by trading price-vs-NAV deviations, but this coverage can miss the value and the purpose of the ETF. While mutual funds are designed to deliver the liquidation proceeds of sold securities, ETFs are actually designed to trade – not to deliver the underlying assets, or even the proceeds from an immediate sale of the underlying assets.
Further, because of their operational simplicity and liquidity, even the largest and most sophisticated institutions have substituted away from swaps, futures, and other instruments to ETFs in many areas of trading, investing, and risk management.
ETFs as Replication & It’s the “Not Trading” That Helps.
Every ETF primer beats the reader over the head with the cornerstone of in-kind creations and redemptions, and how seemingly every ETF share trade occurs with an exchange of the “real” assets. In practice, most ETF shares trade without moving underlying assets – it is the ability of the ETF shares to trade independent of, and more frequently than, the underlyings which brings much of the ETF advantage.
Viewed by some fund veterans, ETF trading prices are only correct if they equal the fund’s NAV. In contrast, viewed from a market structure perspective, an ETF trading price is a classic exercise in replication and separate markets, not unlike the replication exercises which occur in other markets (Black-Scholes-Merton options pricing, and futures markets to name a few). While fund veterans may view the pragmatism (and reality) of this replication process as an ETF short-coming (i.e. ETFs aren’t as “accurate” as other funds), it is this replication process which delivers the unique efficiencies and benefits.
Remember that % of an ETF’s investors are not getting the assets, they’re getting the trading price of the shares. So where price/NAV deviations exist, it’s important to look for all the properties around the deviations (are they unidirectional? are they consistent? is there a tax property? is it relative liquidity?, etc.). As a simplification, if an ETF has consistent or predictably stochastic premiums or discounts, it can be highly tradable and highly valuable. It’s important to remember that, when done right, an ETF does create a different security.
What To Do
While ETFs usually enjoy an expense ratio advantage (and sometimes enjoy a taxable income advantage), ETF share prices can deviate from the value of their underlying assets (NAV). It’s important to evaluate the bundle of ETF attributes, when looking at ETF trading prices. In particular, where ETF prices have a stochastic or non-stationary relationship to asset NAVs, special opportunities can exist (in certain instances trading price deviations are an additional avenue for index convexity or gamma – but this discussion is best left for a future post). Further, unless you’re operating as a special class of market maker (an Authorized Participant) who facilitates in-kind creation and redemption exchanges, you care exclusively about first-order ETF prices rather than second-order NAVs.
All that said, premiums and discounts should never be cavalierly dismissed, but instead should be evaluated in the context of the specific ETF, and what it delivers through its trading prices.
While much is written about how the $18 trillion in domestic investable funds will get split between ETFs and mutual funds, the likely outcome is that ETFs have further to run, while the mutual fund format remains viable. ETFs are unlikely to entirely replace mutual funds, and mutual funds are likely to maintain an advantage for some strategies and for some managers.
As ETFs become larger and more capable, it is important to remember the most important (and most forgotten) principles of an ETF:
"an ETF is designed to trade, and for % of its holders, it delivers an ETF trading price rather than assets or the proceeds from asset sales (as in a mutual fund)"
"by design, it delivers a bundle of attributes which impact on its value (and theoretically its price) relative to NAV"
"it can acquire a market autonomy, where trading prices purposefully deviate from a NAV calculation"
"deviations between trading prices and NAVs are not necessarily bad or erroneous"
"for all investors and traders, it is equally important to understand both the stochastic nature of any price-to-NAV deviations as well as their magnitude"