A Preventable ETF Trading Hiccup

A cautionary tale: Master limited partnership fund briefly trades well above its fair value.

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Senior ETF Specialist
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Reviewed by: Paul Britt
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Edited by: Paul Britt

A cautionary tale: Master limited partnership fund briefly trades well above its fair value.

One of the oft-cited advantages ETFs have over mutual funds is that they trade like a stock.

Tradability is a two edged-sword, however. That’s especially true for investors used to mutual funds, where trading isn’t a concern. With mutual funds, investors get in or get out at fair value. This approach comes with downsides of its own, a topic for another day.

The focus here is poor execution in ETF-land: what it looks like, why it happens and how to avoid it.

Our real-world example is the Etracs Wells Fargo MLP ETN (MLPW). MLPW is an MLP ETN—pardon the double acronym. It’s an energy infrastructure play delivered as a debt instrument rather than a basket of securities. None of that matters though when looking at the trading anomaly that took place on Aug. 14. Check out the graph below.

MLPW_Price_vs_FairValue

Something is wrong with this picture. On Aug. 14, the price of MLPW, in light blue, closed up 19 percent. While that sounds like a windfall, here’s the problem: The fund’s fair value, in dark blue, increased by less than 1 percent on that day. Then, on Aug. 15, MLPW’s price fell back to earth.

This is a premium/discount problem. The fund traded, very briefly, at a severe premium; in other words, well above its fair value. The goofy trades occurred toward the end of the day, so the closing price reflects the inflated price.

I’m betting this mispricing likely took place due to a market order (more on this shortly) in this thinly traded product. The price shot up within the last 10 minutes of trading but reversed itself the following morning. This was not a technical glitch; more likely, it was a poorly executed traded in a fund with little tolerance for such things.

While small in scope, there’s real harm done here: The buyer or buyers who bought these particular shares now need a huge gain just to break even.

To avoid this outcome:

  • Check trading volume data on sites like ETF.com. “Strong” trading volume or “tight” spreads in one context might be weak in another, so compare similar funds for reference.
  • Compare the ETF’s price history with peer funds. A big spike or drop relative to similar funds is a red flag going forward.
  • Trade with limit orders—ideally set close to the fund’s intraday fair value—rather than market orders. While intraday fair value can be hard to obtain, even a limit order set close to prices earlier in the day would have prevented the MLPW’s inflated trades.
  • If the fund hasn’t traded a single share for an entire day recently, find another ETF.
  • Asset levels (AUM) are a crude but helpful approximation of liquidity, especially for smaller trades. Again, peer comparison provides context.
  • Size matters. Some funds that trade poorly in small quantities can be fairly traded in size. Work with a liquidity provider or the fund’s issuer.

Bottom line: MLPW’s trading hiccup was material, but brief. The product isn’t fundamentally broken or structurally flawed; it just isn’t very popular. Just like high school, popularity counts for a lot when trading ETFs.


At the time this article was written, the author held no positions in the security mentioned. Contact Paul Britt at [email protected] or follow him on Twitter @PaulBritt_ETF.

 

Paul Britt, CFA, is a senior analyst in the ETF Analytics group at FactSet, a team that maintains and develops an industry-leading suite of ETF-related data and analytics products. Prior to joining FactSet in April 2015, he was a senior analyst at etf.com, where he performed a similar role, and worked in private placement at Pensco Trust. Paul holds a B.S. from RIT and an M.S. in financial analysis from the University of San Francisco.