In ETF trading, discounts come and discounts go.
Or they're supposed to, anyway. Usually, trading discounts and premiums to net asset value (NAV) get arbitraged out by authorized participants (APs) in relatively short order, and in fact, that competitive profit-seeking is the secret sauce to what makes ETFs actually work.
Sometimes, however, dislocations between an ETF's price and NAV can persist. That's when things get complicated.
Case in point: the Global X MSCI Nigeria ETF (NGE), a relatively small fund, with $32 million in assets, trading with an outsized trading discount. As of Aug. 4, the fund's discount to NAV had hit 18.2%, by far the largest such discount of any U.S.-listed ETF:
Source: ETF.com; data as of Aug. 3, 2020
NGE's discount exists, essentially, because ETFs aren't just a collection of securities. They're a trading vehicle—and sometimes, that vehicle gets a flat tire.
Pandemic Hits Oil-Rich Nigeria Hard
NGE's discount to NAV has persisted for months. It first widened in early March, then struck -13% to NAV on April 30. It's remained in the double digits ever since.
You've probably already guessed the root cause: COVID-19. The global pandemic has had a dramatic impact on the Nigerian economy, which NGE tracks.
The ETF holds 21 companies that are among the largest and most liquid operating within Nigeria's borders. Although roughly half of the portfolio (49%) is in financials, Nigeria's economy is dominated by oil. Not only does the country hold the largest natural gas reserves in Africa, it's the continent's largest oil exporter as well. Almost all of Nigerian exports are connected to the oil industry in some fashion.
This means that 2020's plummeting oil prices and sinking energy demand hit the country hard. Exports have plummeted, crashing Nigeria's economy, which had only just begun to recover from its last recession, one that began the last time oil prices sank, back in 2014.
Multiple Exchange Rates In Nigeria
Yet plenty of countries, even oil producers, are in a similar economic pickle to Nigeria right now. Why should a pandemic be having such an outsized impact on NGE?
It comes back to currency—or the lack thereof.
Back in 2015, the Nigerian central bank implemented multiple exchange rates for its currency, the naira. The goal was to boost the economy by encouraging foreign investment and accommodating brisk demand for the U.S. dollar from investors heading toward the exits. Today the naira has four distinct exchange rates against the dollar, and the currency trades via several forex windows in the country.
The system was never meant to be permanent, and recently, Nigerian officials have stepped up efforts to reunify the naira around one of the exchange rates, the “nafex” (doing so may even be a requirement for international aid from the World Bank or IMF). But should reunification happen, the existing disparities in the exchange rates could lead to a de facto devaluation of the naira, and the Nigerian central bank has already devalued the naira three times this year so far.
Big-Ish Redemptions In NGE
As the naira has weakened from the central bank's devaluations, some exchange rates were impacted more than others, driving speculators toward the forex market. Furthermore, foreign investors are also pulling their money out of the country—as they are from many emerging markets—preferring to instead invest in safer havens around the globe.
Back in the States, we also saw investors pull their money out of NGE. Since Feb. 1, the ETF saw two big (well, relative to NGE's AUM and usual trading volume, anyway) redemptions: One for half a million dollars on March 17, and another for the same amount on April 24.
You might remember that these roughly correspond to big drops in the crude oil market. It's all connected.
Source: ETF.com; data as of Aug. 3, 2020
Unsurprisingly, Nigeria is experiencing a shortage of U.S. dollars: The Central Bank of Nigeria has even ordered banks to stop processing certain commodity imports, in an effort to conserve their store of the currency—meaning low forex liquidity has become endemic in Nigeria, and that's making it tough for APs in the U.S. to do their jobs.
Real-World Impact Of Currency Risk In ETFs
APs performing creates and redeems for international equity ETFs need a plentiful supply of domestic and the relevant foreign currency. After all, NGE is invested in naira-denominated stocks, and you can't buy Nigerian-listed stocks with dollars—you need naira. Plus, even if an AP can perform a redemption in local currency, eventually they'd have to convert naira back to the greenback.
That is why Nigeria's dollar shortage is such a problem.
So while theoretically nothing structural is stopping an AP from creating or redeeming shares of NGE right now, few APs are willing to take on the currency risk necessary to transact in the fund.
Discount In NGE Likely To Persist
As we said above, most ETFs trade at prices fairly close to their NAVs, because if at any time a dislocation opened up, an AP simply can go in, create or redeem ETF shares as needed and arbitrage the spread, making money on the difference. This act of creating and redeeming shares inherently pushes the ETF's price back in line with NAV.
But when you can't create or redeem shares easily, those discounts or premiums to NAV can persist. And that's what we've seen in NGE.
How long will NGE's discount last? Probably for as long as the currency crisis in Nigeria does—and that's subject to many factors, including oil prices, economic recession, and the development and distribution of a vaccine.
So to quote The Good Place: "Shouldn't take long. Between an hour and eleven months."
Contact Lara Crigger at [email protected]