ETF Volatility: The Story Behind The Story

July 12, 2013

Are ETFs really more volatile than mutual funds? Depends on how you look at it.

This morning Bloomberg published a story titled “ETF Simplicity Betrayed by Volatility in Market Selloff.”

In the article, the authors contend that they’ve run the numbers, and that ETFs are just flat-out more volatile than mutual funds. Here’s the lead:

“Share prices for the 10 largest diversified emerging-market ETFs on average were 42.6 percent more volatile than their underlying indexes from May 22 to June 24.”

Let’s break down what they could possibly mean here, and let’s start with a few baselines.

While the article claims it’s not addressing the issue of premiums and discounts—that is, how far off fair value a given ETF closes in market trading versus its underlying index—it’s fairly clear that’s not the case. If it were, then the following chart wouldn’t make sense.

This is a rolling look at the 20-day historical volatility of the iShares MSCI Emerging Markets ETF (NYSEArca: EEM) and the actual index it tracks, over the period in question. I’m looking here at the actual NAV, and as you’d expect, they track extremely closely:

EEM VOL

The bottom line looks at the difference, and you might ask: “Well, why is there any difference at all?”

The reality of any kind of portfolio management is that fund accountants have to make certain assumptions about the price of underlying securities—whether they’re the accountants at MSCI calculating the index level, or the accountants for EEM.

They make different assumptions about things like when to strike exchange rates, or what the true closing price is for a security that didn’t trade today. Those show up as minor variations, which we see here in the slight differences in trailing volatility. Regardless, clearly, 17.89 is not 42 percent more volatile than 17.74.

So for this to be remotely true—and I’m guessing there’s good math behind the slightly wooly words somewhere; they just don’t show us—they have to be looking at the closing trading price. They say as much in the article.

And here’s the thing—closing prices of ETFs are more volatile than their underlying markets in certain cases. In markets where liquidity is an issue, we see this pattern played out over and over again. It’s not just a matter of what goes on in emerging markets:

EEM vs NAV

We also see it in bonds. Here it is in AGG, the iShares Barclays Aggregate Bond ETF (NYSEArca: AGG):

AGG

So the real issue isn’t this inarguable fact, but what’s actually going on. And there are a few answers.

 

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