ETFs Face Scrutiny Amid Market Turbulence
June 24th 2013 at 1:24pm by John Spence
Media reports are questioning the stability of ETFs after last week’s market rout caused some products to deviate from fair value, particularly funds tracking muni bonds.
However, investors need to keep in mind that the ETF structure doesn’t magically protect them when the asset class they’re tracking is stressed. There is no getting around the fact that ETF spreads will widen when liquidity dries up or investors rush for the exits in illiquid sectors. That’s the trade-off for the ability to buy and sell ETFs during the day, unlike mutual funds.
There are appear to be three main investor concerns, centered on emerging market ETFs, a redemption halt by Citigroup, and muni bond funds.
First, some media outlets pointed to discounts from net asset value (NAV) in emerging market ETFs last week. However, this isn’t really an issue because ETFs tracking foreign stocks trade in the U.S. while their underlying markets are closed.
Therefore, data on indicative value is “stale” and the ETFs can fluctuate based on expectations of where the overseas markets will open the next day.
“The main issue with funds that track emerging market securities is that most of the underlying holdings do not trade during our market day,” said Morningstar ETF analyst Patricia Oey in an email. “So the ETF is essentially a price discovery vehicle for that asset class. Widening spreads for emerging market ETFs reflect the market’s anticipation that emerging market stocks will fall further when their markets open. And at the end of our market day, these ETFs tend to close at a discount to their NAV on days like [Thursday of last week].” [Should You be Worried About Your Emerging Market ETF?]
The second part of the story — Citigroup’s temporary redemption freeze – has put the complicated ETF creation and redemption process in the spotlight.
The Financial Times originally reported last week that Citi stopped fulfilling redemptions Thursday after the bank’s ETF desk hit internal capital limits on collateral.
“Heavy trading in ETFs that track securities in parts of the world not open during segments of the US trading day means that dealers must post collateral when they seek to redeem cash or the underlying asset from issuers of the ETF,” the FT explains.
Although Citi stopped acting as an agent for clients wanting to redeem large bundles of shares directly with ETFs, at no point did the bank stop its market-making activities in ETF products, Bloomberg News reports.
Other ETF liquidity providers continued taking redemption orders, according to the article.
Citi halting redemptions didn’t impact small investors that traded ETFs.
Smaller ETF transactions happen on an exchange where buyers and sellers simply swap shares.
However, big trades involve financial institutions and large blocks of ETF shares known as creation units.
These trades take place between firms known as authorized participants, or APs.
New ETF shares are created when an AP sends the ETF manager an appropriate basket of securities, such as stocks or bonds. The fund manager creates the ETF shares and delivers them to the AP.
Conversely, when ETF shares are redeemed, the fund manager turns the basket of securities back over to the AP. [A Quick Primer on ETF Tax Efficiency]
Redemptions can be done “in-kind” or in some cases the ETF manager will deliver cash to the AP, for a fee.
Next page: Muni bond ETFs in turmoil