In our numeric example of ETF market-on-close trading, the net asset value of the fund is $25.00. The midpoint between the bid and offer at 4:00 p.m. is also $25.00. Yet barring a last-minute MOC sell order or a new limit order to sell at least 2,000 shares at less than $25.30, market-on-close orders will be filled at $25.30, 1.2 percent above the net asset value. The ETF’s premium/discount calculation for the day will show the “market price” based on the bid and offer at 4:00 p.m. matching the net asset value at 4:00 p.m. Publication of a zero premium or discount based on 4:00 p.m. quotes relative to NAV encourages ETF investors who do not understand the transaction mechanism to use MOC orders incautiously.
While the premium/discount information published for ETFs is calculated as the prospectus says it is, this calculation has led to unanticipated results for many investors. Even if some professional investors find market-on-close ETF executions useful at times, I can think of no reason why a typical investor should use an MOC order to trade ETFs. For actively traded ETFs, the intraday market in the last hour of trading operates well, and spreads are among the tightest of any time during the day. For less actively traded ETFs and for investors who want a more easily managed trading option, the NAV-based market—described at length in the next section—will usually deliver executions closer to and more consistent with net asset value than either an intraday or an MOC execution. The availability of NAV-based secondary market trading will assure that an investor can lock in a price related to a specific net asset value calculation. Investors can access trading liquidity available during the entire period that the NAV-based secondary market is open—a full-day trading session, at minimum.
If defined contribution plans like 401(k)s and advisers accustomed to buying and selling mutual funds at net asset value use MOC orders for ETF transactions, the deviation of market-on-close executions from NAV may increase as these plans and advisers make greater use of ETFs, especially less actively traded ETFs.7
Introducing NAV-Based Trading In ETFs
As noted in the opening paragraph, one of the compelling advantages of most ETFs for long-term investors is that each shareholder pays only the cost of his or her own fund share transactions and is protected by the ETF structure from the cost of other investors’ purchases and sales of fund shares. Net asset value-based trading in ETF shares preserves this protection from other investors’ fund share trading costs and enables investors to buy and sell ETF shares at a price related to—and no further than a predetermined distance from—net asset value. We will see that, in contrast to trading cost uncertainty in the intraday trading of ETF shares “just like a stock,” NAV-based trading makes it possible for investors to know and control their ETF transaction costs with minimal order monitoring.
Entering an order to buy or sell ETF shares at or relative to the current day’s NAV is only superficially like entering a limit order to buy or sell shares in the traditional intraday ETF market. Buy and sell limit orders are entered and executed relative to a proxy of 100.00 for the per-share net asset value that will be calculated based on the value of the ETF’s portfolio at 4:00 p.m. A transaction at net asset value plus 1 cent per share would be recorded at 100.01. If the fund’s NAV for the day turns out to be $20 per share, the 100.01 would translate to a price of $20.01 because each .01 translates into $0.01 (1 cent) per share. (We omit $ signs on the proxies to avoid the implication that the transaction will occur near $100 per share; 100.00 is merely a reference point.)
Most investors will want to check current bids and offers in the NAV-based market before entering orders in the conventional intraday market. The NAV-based quotation might be stated as “10,000 Bid at 99.99, 20,000 Offered at 100.01” reflecting buy orders totaling 10,000 shares at one penny below the end-of-day net asset value, and sell orders totaling 20,000 shares at one penny above the end-of-day net asset value for the ETF. It may be possible to buy ETF shares below the NAV or to sell them above the NAV, depending on the bids and offers available in the market over the course of the trading day. Even if a standing limit order to sell below NAV is not available in the marketplace when an investor checks the quote, an investor can place his own bid below net asset value at the market close, and that bid may be hit by an order to sell during the course of daily trading activity. Limit orders can be cancelled and new limit orders or market orders can transact with the limit order book until shortly after the close of traditional ETF trading. Transactions will occur throughout the day at or relative to NAV and the dollar execution price will be determined when the NAV is published shortly after 4:00 p.m. After-hours trading relative to the current day’s and the next day’s NAV will also be possible.