There have been a lot of scary articles in the mainstream media about exchange-traded funds lately. As market volatility increased in June, publications including the Financial Times, the Wall Street Journal and Bloomberg all penned articles warning investors about the perils of investing in ETFs.
The articles were extraordinarily mixed in their quality and accuracy, jumbling together true concerns with absolute misconceptions. Here is a primer that separates truth from fiction, arranged from false fears to real worries.
Fear No. 1: International Equity ETFs Not Trading At NAV
Actual Concern: Almost None
Outlets like Bloomberg and the Financial Times ran scare-mongering articles recently warning investors about international equity ETFs trading away from their net asset values (NAVs).
The Financial Times, for instance, noted after one volatile day that “the share price of the iShares MSCI Emerging Markets ETF fell to a 2.6 percent discount to the underlying asset value.”
This is just silliness. The problem here isn’t with the ETF, but rather, with the rules around how ETFs report their “underlying asset value” or (to use the actual term) “net asset value” (NAV).
All ETFs must report their NAV at the end of each trading day. The calculation involves looking at the last traded price for the securities the ETF holds, adjusting for any currency movements and calculating the NAV. All else being equal, one would expect an ETF’s share price to trade close to the NAV.
But what happens when you have an ETF invested in China? China is on the other side of the world, so its markets are closed during the trading day in New York.
Let’s imagine that something bad happens during the course of the trading day in New York: say, Bernanke hints at a rate rise. All securities -- including our China ETF -- will trade lower, because this is bad for investors.
But the NAV? It won’t move, because the Chinese markets aren’t open. So at the end of the day, the Chinese ETF will trade at a “discount” to its official (but by now very stale) NAV.
That’s not anything to be worried about; the ETF is just engaged in price discovery. When the Chinese markets open up later, you can bet its stocks will “catch up” with the ETF’s share price. We’ve seen this happen over and over again. In fact, that’s just what happened with the Emerging Markets ETF that the Financial Times mentioned.
For most international equity ETFs, NAV is an irrelevant statistic. You can’t buy it; you can’t sell it; and it has no bearing on the true value of the portfolio. International equity ETFs will always trade away from NAV, and that’s OK.
Fear No. 2: Bond ETFs Trading At A Discount To NAV
Actual Concern: Medium
A bigger concern comes with bond ETFs. Many of the same articles that mentioned worries about international equity ETFs also cast shadows on bond funds; here, they have some merit. For instance, Tom Lydon of ETF Trends notes that the iShares S&P National AMT-Free Municipal Bond Fund (MUB) traded at a 3.4 percent discount to its NAV on June 20.
The problem with bond NAVs is different -- and in a way, more dangerous -- than the false concern with international equity NAVs.
Bonds do not trade like stocks. There is no central exchange for bonds, no way to look and see that bond X is worth $102.23. Instead, most bond deals are privately negotiated: The price you get for a bond depends on who you call, how much they want to buy, and how good your relationship is.
To make matters more difficult, the bond market is notoriously illiquid. Many bonds don’t trade for days (or weeks/months/years) at a time.
Put those two together and you have a recipe for uncertainty. Since there is no one agreed-upon price for a bond, ETF issuers calculating NAVs at the end of the day have to essentially guess at the value of the bonds they hold. They do this by contracting with bond-pricing services -- typically large investment banks, data shops or consortiums that use a combination of reported sales, trading desk surveys and algorithms to “estimate” the value of each bond.
The general consensus in the market is that these pricing services, while valuable, become less accurate during times of market stress. When investors panic and liquidity dries up in the bond market, the pricing services tend to overestimate the “value” of a bond compared with what you would get if you actually tried to sell it. In other words, they will say that a bond is worth $100 when (in the midst of a market panic) the best actual bid to buy it might be $95.
If this sounds strange, think back to the depths of the housing crisis in 2008. Ask yourself: What was the fair value of your house at the depth of the crisis? Now, ask yourself: At what price would you have had to sell your house on a single day, say October 12, 2008?
I’m guessing the prices are different.
Prices during market-crisis periods are incredibly volatile and hard to estimate. Pricing algorithms fail to take into account human nature, which, during periods of market stress, will demand an unusually good price before they actually trade a bond.
The net result of this is that when the bond market goes south, bond ETFs often trade at a discount to their stated NAV.
What does that mean for you? Like any illiquid asset, the best time to sell a bond ETF is not during a panic. You’ll get a fair price, but it may not be the price you want.
(Note: If the idea of not being able to trade at NAV scares you, the alternative is probably worse. Think of what happens to a bond mutual fund during a crisis. Mutual funds, unlike ETFs, are required to allow investors to redeem shares at NAV. If a lot of investors sell out of a bond mutual fund during a crisis, it will have to sell enough bonds to pay out the full stated NAV in cash. If this NAV is artificially inflated compared with the true clearing price of the underlying bonds, the fund will have to sell more of its portfolio than it “should,” harming all the shareholders who don’t sell out.)
Fear No. 3: The Winkelvoss Twins Launching A Bitcoin ETF
Actual Concern: High
If you want something to worry about, consider this: The Winklevoss twins of Facebook fame have filed to launch a “Bitcoin” ETF.
Bitcoins -- the technological pseudo-currency beloved by money-laundering libertarians everywhere -- have historically been difficult and/or scary for most investors to buy. But now the Winklevi … working with some of the most sophisticated ETF lawyers in the world … have come up with a way to package Bitcoins into an exchange-traded product that you can buy and sell in your Schwab account.
What could go wrong? How about everything.
Beyond the fact that Bitcoins are a virtual currency with no real underlying value, the filing for the Bitcoin Trust outlines 18 pages of risks and concerns that investors should worry about. Among them? As a great blog on the Wall Street Journal reports, there is the concern that hackers could break into the Bitcoin Trust, uncover its “private keys” and steal all the money. To quote the prospectus via the WSJ blog: “there is a risk that part or all of the trust’s Bitcoins could be lost, stolen or destroyed.”
I particularly love the use of the word “lost.” You can imagine the custodian wandering around saying, “Oops! I know those Bitcoins are around here somewhere. Could you help me look under the sofa?”
ETFs have done an amazing job opening up new areas of the market to investors, from international debt to emerging market equities and more. But sometimes, things can go too far.
(Advance Disclosure: Just because I think this is a terrible idea for investors does not mean it’s a terrible investment. In fact, I wouldn’t be surprised if we saw Bitcoins run up in anticipation of the Winklevoss launch. Hmmm … maybe I should buy some Bitcoins.)