Content provided by Josh Jenkins, CFA, CLS Associate Portfolio Manager
I frequently see commentary in the financial media warning about exchange-traded fund (ETF) liquidity. One major fear is if an ETF’s underlying securities stopped trading, the ETF could cease to function correctly. The risk, some argue, is large premiums or discounts could arise, which would move the ETF’s market price far away from its true value, as represented by the fund’s net asset value (NAV). If investors were unknowingly trading in such an ETF, they could get seriously burned.
What Would Cause the Premium or Discount in This Scenario?
The market price of a security adjusts each time it is bought or sold. If the underlying securities of an ETF stop trading, then their prices would not move, which in turn would keep the ETF’s NAV from moving. If the ETF continued to trade while the market for the underlying security was frozen, then the ETF’s market price could move significantly away from its NAV.
Is This Fear Justified?
Those within the ETF industry have countered this fear with the assertion that premiums and discounts are not erroneous price dislocations but instead are what they refer to as “price discoveries.” This can be explained as follows: If the securities in a particular market were to stop trading, investors could potentially use an ETF that tracks that market to add or reduce exposure. As investors continue buying and selling the ETF based on new information, the market price of the ETF will move away from the stationary NAV. In this scenario, it is not the market price that is incorrect but the NAV of the ETF that has been unable to adjust to evolving market conditions.
Can the Concept of Price Discovery be Tested?
If only we could test this theory on a market with an active ETF that shut down for an extended period of time. As it turns out, the Greek debt negotiations offered that exact opportunity when the Athens Stock Exchange (ASE) closed for roughly five weeks recently (June 26 – August 3, 2015). During this period, the Global X FTSE Greece 20 ETF (GREK) traded at a discount to NAV as large as 18%, as it was essentially the only way to estimate the ASE’s reopening price. Was price discovery evident? Judging by this graph, the ETF reflected an extremely accurate estimate of the true market price.
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The graphs and charts contained in this work are for informational purposes only. No graph or chart should be regarded as a guide to investing. CLS is not affiliated with any of the companies listed above. While some CLS portfolios may contain one or more of the specific funds mentioned, CLS is not making any comment as to the suitability of these, or any investment product for use in any portfolio.
An ETF is a type of investment company whose investment objective is to achieve the same return as a particular index, sector, or basket. To achieve this, an ETF will primarily invest in all of the securities, or a representative sample of the securities, that are included in the selected index, sector, or basket. ETFs are subject to the same risks as an individual stock, as well as additional risks based on the sector the ETF invests in. Net asset value, or NAV, is the price per share of a particular mutual fund or ETF. NAV is calculated by dividing the total value of all securities, less liabilities, by the number of shares outstanding.