ETF premium/discount charts like the one for the iShares MSCI EAFE ETF (EFA) below often make ETF investors nervous, because they imply that it’s more likely than not that customers will be hit with a significant premium or discount when buying or selling an ETF. That’s a pity, because most of the time, that implication is just not true.
EFA’s Phantom Premium/Discount Variability
ETFs like EFA trade very close to their instantaneous fair value. EFA trades $1.38 billion/day, at an average daily spread of 0.01%. EFA’s arbitrage mechanism works, since market makers can buy and sell its portfolio of developed-market securities with little difficulty.
EFA’s strong volumes and tight spread make it clear that multiple arbitrageurs compete for order flow. The twin forces of the profit motive and competition keep EFA’s bids and offers in line with its portfolio value. This is confirmed by EFA’s one-year median premium of 0.06%, largely attributable to its 0.04% creation fee.
But the median premium isn’t the whole story. Investors’ apprehension comes not from the central tendency (the red trendline in the chart), but from the wild swings around it. Did EFA really close at a 3.14% discount on Feb. 5, 2018, only to bounce to a 2.03% premium the next day?
While EFA’s end-of-day NAV was out of line with its closing market price, EFA was still trading in line with its portfolio value. EFA’s premium/discount variability is just a statistical artifact.
Time Zone Issues
EFA holds foreign (developed ex-U.S.) stocks only. EFA’s fund accountants must price every security in order to calculate end-of-day net asset values (NAVs). The pricing has two parts: security valuation and currency translation. Local market closing prices do the trick for security valuation; the currency translation uses WM Reuters rates, which are set at 4 p.m. GMT (10 a.m. ET). Yet EFA trades continuously through 4 p.m. ET. When after-hours security trading or currencies go wild after 10 a.m. ET, EFA’s NAV is bound to be stale. The result: an ugly premium/discount chart.
The existing solution, intra-day NAV (iNAV), is actually only a half-measure. iNAV updates every 15 seconds, with real-time currency translations, but it makes no adjustment for any updated security valuations. Stocks like Nestle, Novartis and HSBC, EFA’s top holdings, keep trading long after European markets close, as illustrated by this 12:48 p.m. ET (9:48 a.m. PT) quotes montage (which incorporates a 15-minute delay) for Nestle.
(For a larger view, click on the image above)
You can be sure that market makers who post bids and offers in EFA are using up-to-the-minute security prices, not stale official closing prices, to calculate EFA’s value. Because of this, a premium/discount chart based on iNAV will be less wrong than the EFA chart above, but it won’t be right.
For funds whose NAVs are not synchronized with U.S. equity market closing times, phantom premium/discounts like the ones in EFA are the norm. That’s why ETF.com’s Dave Nadig suggested that the SEC require ETF issuers to flag or footnote premium/discount results for funds with “exchange hours overlap issues.”
There are three kinds of issues that can skew premium/discount results: NAV synchronization, security valuation practices and illiquidity. Let’s look at each one in turn.