Weakness in ETFs Highlights Strength in Mutual Funds
Buyers of ETFs beware, as last Thursday’s selling exposed a fundamental weakness in the structure of the exchange traded fund. Unlike a mutual fund, which allows the investor to buy or sell at the daily net asset value, ETFs can trade at a premium or discount to their net asset value (NAV). At any point in time, an investor can overpay for an asset (i.e. premium) or receive less than the asset is worth (i.e. discount).
These premiums and discounts can be tremendous on days with big NAV changes, as investors realized Thursday. The chart below shows the NAV trading premiums and discounts for the MSCI Emerging Markets Index ETF (EEM) over the past year. As you can see, the ETF often experienced significant premiums and discounts in this time frame; however, the discount was never as severe as it was last Thursday. As panic selling set in last week, the discount grew to be as much as 2.56%. Simply stated, “at the very moment of maximum selling, the ETF exacts the maximum trading cost from the seller (and rewards the buyer similarly, with a discount),” says Brendan Conway from Barron’s.
He explained the difference in the pricing of the MSCI Emerging Markets Index compared to the underlying ETF. Using data from Morningstar, he writes:
“iShares fund enters Friday’s trading session with a closing Thursday market price of $36.88. But the NAV is $37.85. It’s about a full dollar higher. View it in total-return percentage terms: EEM’s market price was down by 16.4% as of Thursday’s close. But the NAV had only lost 13.2%.”
Conway’s contrarian lesson for ETF investors: “Don’t sell into a panic. ETFs are built to penalize lemmings and reward contrarians.”
When it comes to investing, I believe there is no such thing as a free lunch. ETFs have relatively low expense ratios compared with actively managed funds in the same sectors, but that doesn’t mean that in the end an ETF costs less to own or that an ETF generates better returns. On volatile days such as last week on Thursday, ETFs can be expensive to trade.