How ETF Structure Comes Through In A Crisis

July 31, 2014

ETF premiums and discounts save investors money.

If you haven’t been attending ETF.com’s ETF University webinar series, you’re missing out. We’ve been walking through the ins and outs week after week of how ETFs really work, and Tuesday’s fixed-income session was fantastic.

One of my favorite parts of work like that is the kind of feedback we get from attendees, and here’s a great question we were asked:

“I recall hearing about difficulties in the muni fixed income ETF space last year and I believe it stemmed from AP [authorized participant] unwillingness to take delivery in kind and/or PM [portfolio manager] unwillingness to sell bonds at a fire-sale price. In a broader liquidity crunch combined with a mass sell-off, is there any expectation as to how bond ETFs would perform? I suppose this could apply to any asset class, but given the lack of liquidity in the fixed-income market that already exists, and dealer unwillingness to take on inventory, could they simply stop taking delivery in-kind, and would this lead to extreme discounts?

“I think in a mutual fund, PMs would just be forced to liquidate their positions and take a loss. But does reliance on the AP community expose ETFs to additional risk in these crisis-type scenarios?”

It’s a great question, because it illustrates so clearly why the ETF structure is actually better for long-term investors in times of crisis than a traditional mutual fund.

To see how that could possibly be, let’s paint a picture of how APs and ETF issuers interact. First, let’s examine a “normal” period in a less liquid ETF. Here’s what the ETF.com tradability charts look like for the Global X Gold Explorers ETF (GLDX | D-22):

GLDXPD

This is an ETF that generally only trades 40,000 or so shares a day. And you can see, because of that, investors are used to paying fairly wide spreads of between 0.60 and about 1 percent (the top chart). Those spreads are centered, generally, around fair value.

The bottom chart shows the premium or discount to fair value each day. On the average day, it’s trading at fair value, but there is a fair amount of variability—some days it trades at 1 or 2 percent over, some days 1 or 2 percent under.

So what’s going on here? Well, the APs for GLDX watch it trade. When there’s a lot of demand to buy it, the price will be bid up in the market to a premium. When the premium is high enough, the AP will pounce, selling shares in the open market at the slightly inflated price, while buying up all the underlying stocks.

At the end of the day, they’ll hand the stocks to Global X, and get shares at fair value. They get to book a profit on the difference between what they sold the shares at in the market earlier that day, and the true cost of the underlying.

It’s exactly how the process is supposed to work. With a less liquid ETF like GLDX, the premium swing is noticeable and meaningful to investors (although definitely manageable with careful trading). It’s worth nothing that the exact same thing goes on in the SPDR S&P 500 ETF (SPY | A-98), it just happens at basis points instead of percentages, and so escapes most investors’ notice.

But what happens when investors really want to get in or out of an ETF, precisely when the market for the underlying securities is going insane?

 

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