Many clients interested in ETFs are concerned that they will get a raw deal on the trading floor. They worry about being overcharged on the buy side or having to sell at a discount. Recent news about a premium spike in the ETFMG Alternative Harvest ETF (MJ-US), the so-called marijuana ETF, has amplified this concern.
At the same time, the SEC has proposed a rule change designed to modernize the regulatory framework for ETFs, including the elimination of a requirement to publish intra-day ETF NAVs (iNAV) at 15-second intervals. This particular change would seemingly limit investors’ ability to measure the fairness of intra-day ETF bids and offers. However, published comments on the proposal by the Investment Company Institute, ETF.com, and BlackRock agree that abolishing iNAVs is desirable. In fact, Dave Nadig, managing director at ETF.com, has taken the recommendation one step further, stating, “we would suggest that the SEC require that premium/discount be flagged and footnoted when it is known to include inaccurate data due to exchange-hours overlap issues.”
Are they mad to advocate the removal of a tool that, at face value, allows first-order evaluation of the fairness of bids and offers? Hardly. They’re simply acknowledging that significant premiums and discounts are rare, and that comparisons of trade reports to contemporaneous iNAV and end-of-day premium/discount results often exaggerate the gap between fair portfolio value and the ETF’s market price. The SEC and industry participants are advocating to remove a metric that often creates confusion and misrepresents trading conditions.
The ETF arbitrage mechanism is strong and functional, because it incentivizes ETF market makers to keep ETF prices close to instantaneous portfolio values. When the arbitrage mechanism breaks down (as it may have with MJ-US), the event is newsworthy.
It’s worth taking the time to understand each piece of this conversation. I will address each in turn, in a four-part series. In part one, I focus on the ETF arbitrage mechanism and the power of the profit motive and competition that jointly keep ETF prices in line with portfolio values – and what happens when it breaks down. The second installment will delve into the pitfalls of measuring premiums and discounts. Part three will extend the discussion to show how ETF issuers face a trade-off in aligning their portfolio value calculations, choosing between minimizing expressions of tracking error or premium/discounts. The capstone to the series will measure the effects of these trade-offs and suggest some solutions for improving measurements of pricing fairness and portfolio efficiency.
ETF Arbitrage: Incentive-Driven
The majority of ETFs trade very close to their instantaneous portfolio value. This happens not by luck or mandate, but because of the twin incentives of arbitrage profits and competition.
ETF arbitrage works by allowing market makers to trade ETF shares against the portfolio securities. When a pricing disparity appears, for example when the ETF shares are offered more cheaply than the portfolio, arbitrageurs will buy the ETF shares and sell short portfolio securities, thus pushing ETF share prices up and portfolio prices down. The arbitrage can be completed—and profits realized—because the market makers are able to exchange portfolio securities for ETF shares, at NAV.
The competition piece is simple. Multiple market makers vie with each other to capture the arbitrage process, by competing for order flow. To get into the game, market makers must post lower offers or higher bids. Spreads narrow, often approaching the level of market-making firms’ internal costs.
There is ample evidence that the ETF arbitrage mechanism keeps prices in line with NAVs. For the ETFs that meet the basic liquidity threshold of $250,000 traded/day (excluding bond funds), which includes 82% of all US-domiciled ETFs by AUM, median trailing 12-month daily premiums/discounts are 0.02%, and the mode (the most frequent result) is 0.00%. 68% of these liquid ETFs tend to close the trading day within 0.10% of their fair value.
QQQ: Example of an ETF Trading at Portfolio Value
QQQ is an example of an ETF trading in lockstep with its fair value. Since the beginning of 2011, QQQ has closed at a premium or discount over 0.10% on only 1.3% of trading days; the other 98.7% of the time, QQQ’s closing price is within 10 basis points of its NAV. QQQ’s average end-of-day premium of 0.0005% is indistinguishable from zero.
While the chart above shows only end-of-day premium/discounts, there’s no reason to believe that mid-day trades get poor execution. In fact, the market open and close are notorious for shenanigans, so if the close isn’t distorted, it’s a pretty fair assumption that the rest of the trading day isn’t either. Customers can essentially trade QQQ at NAV at any time.