Trading ETFs: Getting A Fair Price

October 23, 2018

Even Illiquid ETFs Are Generally Priced Fairly

Few ETFs are as liquid as QQQ, but low volumes don’t necessarily create premiums or discounts.

ETF market makers are highly competitive and will step in to trade portfolio securities against ETF shares once a customer places an order, sometimes for as little as a one penny differential.

The Pacer Military Times Best Employers ETF (VETS-US) is a perfect example. On most days, VETS doesn’t trade at all. Yet it is offered at penny-wide spreads because its portfolio of U.S.-listed equities is simple to arbitrage. Market makers have no trouble pricingor shortingportfolio full of Amazon.com, Booz Allen Hamilton, and Union Pacific Corp.

We can see this by looking at pricing on days when VETS never trades (or when all trades are less than 100 shares), when the closing “price” is actually the mid-point between closing bid and offer. VETS’ closing mid-point has remained equal to end-of-day NAV on average, with a range of no more than 0.04%. Putting together spreads and closing market mid-points, we can see that VETS trades at portfolio value, when it trades at all.

Trading Costs Matter

ETF market makers will compete, but not to the point of unprofitability. They wind up passing along trading costs to clients. Most of the time, these costs are minimal, but occasionally this is not the case. That’s when dislocations between trading prices and portfolio values appear.

The ETRACS Alerian MLP Infrastructure Index ETN (MLPI-US) is a good case in point. From MLPI’s launch in April 2010, flows were almost entirely one-way. Market makers were creating shares, but hardly ever redeeming them, so MLPI traded at a tiny premium. However, in June 2017, the situation reversed. Outflows became the rule and inflows the exception. Premia followed the creations, and then discounts followed the redemptions.

 

Flows drive Premium Discount

 

As the issuer of MLPI, UBS charges a redemption fee of 0.125% of the fund’s NAV but does not charge a creation fee. As a result, MLPI’s closing price hovers within a few basis points of closing NAV when funds are flowing in, or when there is no net inflow. However, there is an average 0.14% discount when market makers are hit with redemption fees, as illustrated below. 

 


Source: FactSet

 

 

 

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