The ability to create or redeem ETF shares each day should limit the size of any premium or discount on an ETF share as long as professional traders acting as market makers and arbitrageurs are reasonably attuned to the costs and opportunities of meeting demand for additional shares or redeeming existing shares of the ETF. Transactions in the NAV-based and traditional ETF markets are subject to similar fees and commissions. Information on these costs and trading choices will be available from your broker or adviser. Investors can compare differences in the spreads between contemporary bids and offers in the conventional intraday market and in the NAV-based market throughout the trading day. We have seen that locating the midpoint of the bid/offer range relative to an intraday ETF value is not easy for the average investor in the traditional ETF market. Even if an investor has ready access to intraday NAV proxies based on contemporary bids and offers for an ETF’s portfolio securities, the portfolio value of many ETFs can change by much more than the typical bid/offer spread in just a few seconds. In conventional ETF trading, most investors cannot be confident that their execution will be as close to the contemporary NAV as they intend.
The diagrams in Figure 6 compare limit orders in the NAV-based market (where an unchanged limit order may be appropriate for most or all of the trading day with little need for monitoring) with a sequence of limit orders in the intraday ETF market (where the appropriate level for a bid or offer can change more quickly than most investors can react). The right-hand side of Figure 6 illustrates the variability in the intraday value of the fund and highlights the limit order management problem that most investors face in the conventional ETF market as fund share values change. As noted, an investor’s order can trade only with bids and offers that are available in the market. Orders must be entered in the conventional ETF market to buy or sell at the market or at a specific dollar price, say $20.00 per share. Orders to buy or sell ETF shares relative to a contemporary or future ETF (portfolio) value are not accepted in the conventional ETF market. Orders to trade at or relative to the day’s official NAV are the essence of this new market that lets buyers and sellers express their bids and offers relative to net asset value. The transaction cost to buy or sell an ETF share in the NAV-based market is the sum of any fees and commissions plus (or minus) any difference between the execution price and the net asset value. With limit orders stated relative to NAV, an investor both knows and controls trading costs by this measure, whether the ETF is thinly or actively traded.
Professional traders and market makers understand that the economics of their business is based on volume and risk management. Most of them welcome the introduction of NAV-based trading because it will substantially increase trading volumes in ETFs that are not actively traded today. These market professionals will earn far more from small profits on a lot of trades than from much larger profits per share on very few shares traded. NAV-based trading also gives market makers an additional way to reduce their ETF inventory risk without incurring the costs of frequent creation or redemption transactions in lightly traded ETFs.
While the conventional ETF market usually works well for investors who know how to use it to trade the largest and most actively traded ETFs, it does not serve investors in less actively traded funds very well. Trading costs are high and hard to measure in the conventional market for less actively traded ETFs. When an ETF’s trading volume is low in the conventional ETF market, its bid/offer spreads are often wide, and professional traders have little choice but to respond opportunistically to retail orders rather than to arbitrage pricing relationships.
NAV-based trading increases the opportunity for ETFs based on newly developed indexes to compete with ETFs based on established benchmark indexes. It makes trading easier for advisers who are used to buying mutual fund shares at net asset value. In an extension of trading services, we anticipate the availability of executions based on dollar amounts and fractional shares provided by a financial intermediary to reduce ETF trading costs for defined contribution plans and other accounts that make frequent small transactions. NAV-based trading will facilitate the development of nontransparent ETFs that offer active portfolio management and nontransparent indexes that are not plagued with high composition change costs—in an ETF structure that protects shareholders from the cost of other investors’ fund share purchases and sales.
In an earlier paragraph, I noted that there is statistically significant evidence that the average stock trades at a lower price near the market opening than near the close on the same day. A fund net asset value can be calculated from opening prices as well as from closing prices. If there is demand for it, NAV-based trading around opening or hourly portfolio values as well as the traditional end-of-day NAV calculation is possible.
The author gratefully acknowledges helpful suggestions from the editor, Matt Hougan; participants at the NASDAQ OMX Symposium on Exchange Traded Funds at New York University’s Stern School of Business; and the Nasdaq OMX for the preparation of Figures 3 and 4.
1 Net-asset-value-based trading is covered by two U.S. patents and a number of pending patent applications.
2 Individual investors probably follow similar trade patterns in stocks. The previous comments reflect conventional wisdom, not a systematic study of the underlying cause.
3For discussion of these patterns and references to other research that has found similar patterns, see Heston, Steven L., Robert A. Korajczyk, and Ronnie Sadka, “Intraday Patterns in the Cross-Section of Stock Returns,” March 18, 2009. http://ssrn.com/abstract=1107590. We will return briefly to the issue of intraday price patterns at the end of the article.
4One of the best articles describing this data is by Hougan, Matt, “ETFs, Spreads and Liquidity,” Journal of Indexes, July/August 2008, pp. 30–33. See also one of Hougan’s blogs comparing spreads in October 2007 and 2008, http://www.indexuniverse.com/component/content/article/31/4768-etf-spreads-widen-substantially.html?Itemid=3. The Index Universe website, www.indexuniverse.com, lists monthly ETF average spreads. Click on Section and then on Data.
5 Do not rely on the published IOPV for any purpose.
6 They will use their proprietary value calculations to estimate NAV, not the posted IOPV.
7The most important paper on ETF trading premiums and discounts is Robert Engle and Depojyoti Sarkar, “Premiums-Discounts in Exchange-Traded Funds,” Journal of Derivatives, Summer 2006, pp. 27–45. This paper was reprinted in Bruce, Brian R., A Guide to Exchange Traded Funds and Indexing Innovations, Fall 2006, pp. 36–54. Engle and Sarkar found that ETFs holding domestic stocks had an end-of-day average premium of the closing price over the reported NAV of just +1.1 basis points (a discount would be reported as a premium with a negative sign). However, this tiny average premium is misleading. The average standard deviation of the last trade premium was 42.1 bps with a range of 17.6 bps to 142 bps for various funds. A 42-bp standard deviation is more than four-tenths of a percent of the value of the fund share. Using this standard deviation as a rough indicator of the cost of an MOC execution neglects the effect of “last” transactions that occurred before or after 4:00 p.m. Nonetheless, the average bid-asked spread for these domestic stock ETFs at the close was 37.7 bps. Neither this spread nor the reported premiums and discounts provide a useful indication of the price an investor should expect on an MOC transaction today. The study was based on a set of data that ended in September 2000. The procedures for trading ETFs around the market close have changed in a number of ways since then. The domestic stock ETFs that Engle and Sarkar studied now trade tens of millions of shares daily, but today’s less actively traded ETFs display the same variability of premiums and discounts found in the earlier data. A similar study of contemporary trading in less active ETFs would make interesting reading.