‘Seduced’ ETF Investors Are Caught by Surprise as Prices Diverge

Bloomberg -- David Blain, a financial adviser in New Bern, North Carolina, likes exchange-traded funds so much he’s put all his clients’ money in them. He also thinks individual investors trading ETFs on their own may be in for surprises when markets come under stress.

Share prices for dozens of ETFs last month strayed to their biggest discounts in a year against the published value of their holdings, or net-asset values, as investors fled stocks and bonds around the world. The price of the $362 million iShares MSCI Philippines Investable Market Index Fund swung from a 4.7 percent premium to a 6.1 percent discount and back to a 2 percent premium in the space of nine trading days through June 25.

“I don’t think most people have any clue that the prices they’re paying or selling at can veer significantly from NAV,” Blain, who manages $75 million, said in an interview.

ETFs have become one of the most popular investing vehicles in the past decade, with U.S. assets surging 12-fold to $1.48 trillion, by combining the diversified market access offered by mutual funds with the tradability of a stock. Some more complex exchange-traded products, such as derivatives-based funds or those that use leverage, have recently attracted scrutiny from regulators.

Blain and other advisers serving small clients said recent volatility underlines why additional investors should also be wary of traditional ETFs if they invest in less liquid markets, especially as fund providers sell them aggressively as cheap and easy tools for gaining access to exotic asset-classes and regions.


“I don’t know that the retail investor always comprehends that the education they’re getting comes from organizations that are best served by them buying the product,” said Jim Heitman, an adviser in Alta Loma, California, who manages $25 million, with about 90 percent of that in ETFs. “Within our current regulatory structure, it’s buyer beware.”

ETFs hold baskets of underlying securities and can be traded throughout the day on an exchange, like a stock. Most of the funds are designed to track an index, a key element in keeping down costs, and its underlying assets will largely match that index. The ETF’s price will typically stray little from its net-asset value, or NAV. The price of the $134 billion SPDR S&P 500 ETF Trust hasn’t veered away from its NAV by more than 0.26 percentage point in the past year.

In less liquid markets, or when the ETF trades at different hours than the underlying market, that relationship can widen under stress. The $221 million SPDR Nuveen S&P High Yield Municipal Bond ETF hit a discount of 4.8 percent to its assets last month, the highest in more than a year.


Retail investors get “seduced” into thinking ETF prices will always be close to their underlying asset values, Mercer Bullard, associate professor of law at the University of Mississippi and founder of investor advocacy group Fund Democracy, said in an interview.

The funds are popular with individuals as well as institutions such as pension funds and hedge funds, among the most sophisticated investors and often the first to buy or sell if markets change. The top four U.S.-listed holdings of Ray Dalio’s $140 billion Bridgewater Associates LP, the world’s largest hedge-fund firm, were ETFs at the end of the first quarter.

During last month’s market rout, some retail investors probably sold at a discount and may never know it, said Mark Wilson, chief investment officer at Tarbox Group Inc. in Newport Beach, California, which manages $300 million.

“They’re getting ripped off because they don’t have all the information to make good decisions,” he said.


Selling at a discount or buying at a premium doesn’t mean the investor is getting an unfair price, Matthew Tucker, head of iShares fixed-income strategy at BlackRock Inc., the largest ETF provider, said in an interview. BlackRock is in the midst of a major advertising campaign for its iShares lineup of ETFs, with some television ads focused on international and emerging markets funds.

If a fund’s share price deviates from the last price of its underlying assets, arbitrage traders will jump in and take advantage of the difference, Tucker said. Their buying or selling of ETF shares pushes the share price back in line with assets.

The mechanism only works when those arbitragers can buy or sell the underlying securities at their last quoted price. If the underlying securities aren’t liquid or don’t trade during the same hours as the ETF’s shares, as in emerging markets or high-yield bonds, they may stop that activity.

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Comments (1)
Rock solid article that hit a lot of key points, inluding that in some less liquid markets, discounts are an illusion. It's also true that more investor education is needed. Good work.
Posted by Rusty V | Monday, July 08 2013 at 8:00PM ET
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