You might be aware that some ETFs—notably international stock and bond ETFs—seemed to have had “abnormal price volatility” in recent weeks. Market volatility can have an impact on all investment products, but in this case many investors seemed to question why an ETF’s market price deviated from its stated net asset value (NAV).
The appearance of perceived tracking error for international stock ETFs and the occurrence of premiums and discounts (P/Ds) on bond ETFs are things we’ve discussed in the past.
Fair-value pricing resulting from ETF market transactions throughout the U.S. trading day is the linchpin to understanding these issues. In my earlier blog on international ETF returns, I explained how market participants update an investment’s value based on the most current information available, whereas index returns may use stale prices from markets that closed hours earlier. With respect to an ETF’s market price, this was my summarizing point (new emphasis in bold):
Since international stock markets are closed at the end of the U.S. trading day, market participants make bid and ask prices on international ETFs based upon those participants’ estimates of where the underlying securities would be trading if their markets were still open. It is not uncommon to see large “tracking error” for international ETFs on a market-price basis.
To clarify, there are two levers to consider.
- Tracking error: ETF market price versus the index.
- P/D: ETF market price versus its NAV.
While current news stories have highlighted the premium/discount angle, the underlying issue continues to be the concept of fair-value pricing. The underlying international stocks in the portfolio—the basis for an ETF’s NAV—are closed for trading in their respective local markets while the ETF itself continues to trade. Thus, the ETF represents a more accurate representation of the value of the underlying stocks.