How ETFs Navigate Greece And China Turmoil

Investors have turned to ETFs as a gauge of value on Greek assets following the closure of Athen’s stock exchange on 29 June, and industry experts insist that ETFs are in this case truly acting as a mechanism for price discovery.

ETFs provide liquidity through both the primary markets (market makers creating and redeeming ETF units) and secondary markets (on-exchange buying and selling), and therefore ETFs can continue to trade even when the primary market closes.

At the secondary market level, buyers and sellers are effectively matched through exchange trading without the need to trade in the underlying basket of assets. The additional liquidity this provides enables investors to continue to trade ETFs at prices that are considered to be ‘fair value’, providing both much needed liquidity and a mechanism for price discovery.

What Is Fair Value?

Andrew Jamieson, global head of broker-dealer sales in the iShares capital markets team, said price discovery is simply about understanding the fair value of an asset that is inferred by the global buyers and sellers of that asset.

“ETFs are the ultimate form of price discovery and value – they trade at a price that is representative of the collective views of the market,” he said. “Market participants are not compelled to buy so they will only do so at the price they think the assets are worth.”

The existence of bids and offers for assets are the way in which investors ascertain the value of that asset. Jamieson, draws a comparison to an online marketplace: “If I want to know what the market value of something is, I can look online to see what people are bidding and offering for the same item. That doesn’t mean I have to then sell it, but the platform allows me to understand what the fair value of the item is.”

ETFs can effectively act as the eBay of closed financial markets.

Andrew Craswell, an ETF specialist at private bank Brown Brothers Harriman said: “Closure of the primary market does not prevent an ETF from trading in the secondary market as ETF market participants are prepared to price the ETF based on their own fair valuation of the underlying securities, taking into account the liquidity risk of the primary market being closed.”

Greece Shines Spotlight On ETF Structure

The Greek market has been closed for three weeks as its Governments hammers out a debt relief deal with Europe. However, while that meant there were no bids or offers available for assets listed on the Greek exchange, ETFs listed elsewhere that track Greek securities continued to trade on the secondary market, allowing market participants to buy and sell exposure to Greek assets at what they considered to be fair value.

After hitting $12.1 per share on 23 June, the $300 million Global X FTSE Greece 20 ETF (GREK US), which has a primarly listing on the NYSE, began a downward run. It declined to $11.8 on 26 June before slumping to $9.49 on 29 June when the Greek government shut its banks and stock exchanges. GREK trading volumes spiked the same day, hitting a one-year high of 6.3 million shares, several multiples of its average daily trading volume over that year.

“Many portfolio managers used the GREK US, as their fair value proxy when they priced funds that had exposure to Greece,” Craswell said. “So if GREK US was down 19 percent, they applied a 19 percent haircut to their Greek exposure.”

It is important, however, to draw a clear distinction between whether an ETF is reflective of the price of a market as a whole or purely on the assets included in the underlying basket.

“ETFs hold a small percentage of the overall market,” iShares’ Jamieson pointed out, “and are a reflection of the perceived value of the particular securities in the ETF’s basket of assets, not necessarily the market as a whole.”

Europe Acting Differently

Lyxor suspended subscriptions and redemptions of units in its FTSE Athex Large Cap UCITS ETF (GRE) when Athens closed almost a month ago. Lyxor declined to comment further for this article. Trading was halted on all European exchanges, except on Stuttgart stock exchange.

A statement from Boerse Stuttgart on 21 July noted there had been an average of 118 price determinations per day for the ETF over the last three weeks as the volume of trading picked up, totalling 6 million units, equivalent to more than a third of the total number of units traded since the start of the year.

Watch Out For Price Differentials

Where the primary market for an ETF is closed, investors may experience significant gaps in the market price compared to the NAV, and the fund could fall to a discount.

The discount can create a dilemma for an investor who bought shares in the ETF prior to the suspension of the primary market, but that risk only materialises if the investor plans to trade on the secondary market while the underlying market is closed. Once it reopens, prices for the ETF are once again determined with the aid of a market maker, whose role is to provide a continuous stream of quotes. The gap should therefore correct itself. “This is a timing issue,” Jamieson says.

China Stock Market Turmoil

Similarly to the Greek situation, the last month has also seen ETFs provide price transparency and liquidity for investors wanting to trade Chinese equity exposures after more than half of the country’s listed equities were suspended earlier in July.

ETFs listed on other exchanges continued to trade. The $7 billion iShares China Large-Cap ETF, which trades on the NYSE Arca exchange and tracks the FTSE China 50 Index-USD NET index, saw trading volumes rise dramatically from just under 16 million shares on Thursday 2 July to well over 100.5 million shares by Wednesday 8 July while the market for the underlying assets remained frozen.

Transparency Across The Board

ETFs’ role in price discovery is not limited to times of market stress. They function the same way across time zones in normal market conditions. If a material piece of news came out in a country where the stock market was already closed, for example, investors would still be able to adjust their exposures using foreign-listed ETFs tracking the closed market.

Where ETFs track a basket of less transparent assets, they can also play an important role in price discovery on a continuous basis. This is the case, for example, for ETFs tracking fixed income benchmarks, which is a quasi over-the-counter market. This means it can be hard to see where assets are trading.

“The beauty of ETFs is that they offer transparency around pricing,” iShares’ Jamieson said. “Because ETFs trade like an equity they are very visible and the contractual market-making activity on exchange injects an additional level of liquidity.”