Exchange traded funds allow anyone to access broad markets cheaply and efficiently. However, to fully understand how ETFs effectively mimic a basket of securities, financial advisors and investors will need to take a look behind the curtain.
ETFs trade under a so-called Indicative Value Paradigm (IVP), according to Kelly Haughton, Chief Executive Officer of the Global Index Group. ETFs and other open-end funds are priced based on an underlying basket of assets, or net asset value.
Mutual funds calculate their fair value based on the NAV of the closing price in the underlying market. However, ETFs, which trade throughout the day like common stocks, will require a different set of indicative values to help reflect the shifting ETF prices throughout the day.
The indicative value is an important indicator as it allows behind-the-scenes Authorized Participants or market makers to arbitrage potential discrepancies between an ETF’s price and that of its underlying net asset value, so that the ETF will more-or-less trade in line with the value of its underlying basket of securities. [How ETFs Are Traded]
In an attempt to guide trading on ETFs, the indicative NAV or iNAV provides a more real-time view of value throughout the trading day. The iNAV is typically calculated every 15 seconds during normal hours.
If demand for an ETF outstrips supply, the ETF would show a premium to its iNAV. Consequently, a market maker could step in to borrow shares of stock from an underlying benchmark and put them in a trust to form a so-called creation unit of an ETF, which are then sold to the public on the secondary market, alleviating the premium.
On the other hand, if an ETF shows a discount to its iNAV, a market maker can reverse the process and redeem ETF shares for a basket of underlying stocks.
However, if the markets for the underlying assets are closed or illiquid, arbitrage on the last calculated indicative value becomes difficult and market makers may shift to a so-called Price Discovery Paradigm (PDP) where prices are determined by basic supply and demand forces, Haughton added.
For instance, price discovery is more likely applied to U.S.-listed international stock ETFs where the iNAV may be stale for many hours. Since foreign markets are typically closed during normal U.S. trading hours, a market maker would be unable to find up-to-date indicative values. Consequently, these international stock ETFs will follow normal price discovery and may trade at premiums or discounts to their NAV.
The Global Index Group also pointed out that ETFs have improved liquidity in normally illiquid areas of the market due to the price discovery mechanism. For instance, bid-ask spreads in high yield bond ETFs are tighter than those found in the underlying junk debt securities markets.
“The IVP is not applicable in every asset class or in every time frame. This means investors need to be alert to the trading paradigm of each security to make efficient use of the tool,” according to the Global Index Group. “Some investment tools are bringing additional liquidity to illiquid assets. This improvement in market efficiency helps market participants, but means that investors must adapt to using the PDP much as they do in trading individual securities. One cannot free ride on the Price Discovery in the underlying assets, since it is not happening.”