David Blain, a financial adviser in New Bern, North Carolina, likes exchange-traded funds so much he’s put all his clients’ money in them. He also thinks individual investors trading ETFs on their own may be in for surprises when markets come under stress.
Share prices for dozens of ETFs last month strayed to their biggest discounts in a year against the published value of their holdings, or net-asset values, as investors fled stocks and bonds around the world. The price of the $362 million iShares MSCI Philippines Investable Market Index Fund swung from a 4.7% premium to a 6.1% discount and back to a 2% premium in the space of nine trading days through June 25.
“I don’t think most people have any clue that the prices they’re paying or selling at can veer significantly from NAV,” Blain, who manages $75 million, said in an interview.
ETFs have become one of the most popular investing vehicles in the past decade, with U.S. assets surging 12-fold to $1.48 trillion, by combining the diversified market access offered by mutual funds with the tradability of a stock. Some more complex exchange-traded products, such as derivatives-based funds or those that use leverage, have recently attracted scrutiny from regulators.
Blain and other advisers serving small clients said recent volatility underlines why additional investors should also be wary of traditional ETFs if they invest in less liquid markets, especially as fund providers sell them aggressively as cheap and easy tools for gaining access to exotic asset-classes and regions.
“I don’t know that the retail investor always comprehends that the education they’re getting comes from organizations that are best served by them buying the product,” said Jim Heitman, an adviser in Alta Loma, California, who manages $25 million, with about 90% of that in ETFs. “Within our current regulatory structure, it’s buyer beware.”
ETFs hold baskets of underlying securities and can be traded throughout the day on an exchange, like a stock. Most of the funds are designed to track an index, a key element in keeping down costs, and its underlying assets will largely match that index. The ETF’s price will typically stray little from its net-asset value, or NAV. The price of the $134 billion SPDR S&P 500 ETF Trust hasn’t veered away from its NAV by more than 0.26 percentage point in the past year.
In less liquid markets, or when the ETF trades at different hours than the underlying market, that relationship can widen under stress. The $221 million SPDR Nuveen S&P High Yield Municipal Bond ETF hit a discount of 4.8% to its assets last month, the highest in more than a year.
Retail investors get “seduced” into thinking ETF prices will always be close to their underlying asset values, Mercer Bullard, associate professor of law at the University of Mississippi and founder of investor advocacy group Fund Democracy, said in an interview.
The funds are popular with individuals as well as institutions such as pension funds and hedge funds, among the most sophisticated investors and often the first to buy or sell if markets change. The top four U.S.-listed holdings of Ray Dalio’s $140 billion Bridgewater Associates LP, the world’s largest hedge-fund firm, were ETFs at the end of the first quarter.
During last month’s market rout, some retail investors probably sold at a discount and may never know it, said Mark Wilson, chief investment officer at Tarbox Group Inc. in Newport Beach, California, which manages $300 million.
“They’re getting ripped off because they don’t have all the information to make good decisions,” he said.
Selling at a discount or buying at a premium doesn’t mean the investor is getting an unfair price, Matthew Tucker, head of iShares fixed-income strategy at BlackRock Inc., the largest ETF provider, said in an interview. BlackRock is in the midst of a major advertising campaign for its iShares lineup of ETFs, with some television ads focused on international and emerging markets funds.
If a fund’s share price deviates from the last price of its underlying assets, arbitrage traders will jump in and take advantage of the difference, Tucker said. Their buying or selling of ETF shares pushes the share price back in line with assets.
The mechanism only works when those arbitragers can buy or sell the underlying securities at their last quoted price. If the underlying securities aren’t liquid or don’t trade during the same hours as the ETF’s shares, as in emerging markets or high-yield bonds, they may stop that activity.
In those cases, Tucker said, it’s often the NAV that’s not reflecting the right value. The clearest example occurs when an overseas stock exchange is closed. That means a fund’s NAV will remain frozen even as the ETF shares continue to trade in New York, reflecting current investor sentiment.
“What investors need to understand is that for ETFs in emerging markets or high yield bonds, the ETF does a better job than the index in telling you where the market is at a given point in time,” Tucker said. “The discount is an illusion.”
That isn’t always true, Wilson said. Discounted or premium shares sometimes snap back to the value of underlying assets, and sometimes asset values will move to catch up with share price movements.
“To say the ETF shares are the most accurate is probably overstated,” said Wilson, who stays out of ETFs that track illiquid markets. “I’d rather not have to deal with it.”
BlackRock announced June 29 it was planning a “fresh program for investor education” to help investors understand how ETFs work.
ETF providers should work together to boost investor education efforts, Rick Ferri, founder of Portfolio Solutions LLC in Troy, Michigan, said in an interview. The firm manages $1.2 billion.
“There hasn’t been any real attempt by the industry to get together on this, and there’s been no pressure from the SEC or Finra to make it happen,” he said, referring to the Financial Industry Regulatory Authority, the brokerage industry’s self- funded regulator.
Finra in May 2012 fined Wells Fargo & Co., Citigroup Inc., Morgan Stanley and UBS AG a combined $9.1 million for selling leveraged and inverse ETFs to clients who didn’t understand them and lost money. The body first warned brokers and other advisers about the products in 2009.
“Finra continues to look closely at sales of ETFs and other complex products to assess whether the sale of these products to retail customers are suitable,” Brad Bennett, the group’s chief enforcement officer, said in an e-mailed statement.
Following Finra warnings to investors and advisers on leveraged and inverse ETFs in 2009, discount brokers such as Charles Schwab Corp. in San Francisco and Boston-based Fidelity Investments, which cater to do-it-yourself investors, made it more difficult for self-directed investors to trade those products.
Users of Fidelity’s online trading platform can’t find leveraged and inverse ETFs on the default list of products. If they insist on trading them, they must define themselves as “very aggressive” investors and acknowledge extra warnings about the products’ risks. They also are presented with additional education material.
Customers don’t hit similar hurdles with ETFs focused on illiquid markets. The platform also doesn’t provide current premium and discount data when customers look up individual ETFs. Premiums and discounts listed are from the previous day’s market close.
The firm makes a significant amount of educational material, including tutorials on how to trade effectively, available to clients, Stephen Austin, a spokesman, said in an interview. He said clients also can always get live assistance on the phone or online from Fidelity advisers.
“We’re committed to keeping our investors educated and continuously enhance the research available to them,” Austin said. “In the coming months they’ll see further enhancements to research on ETF structure.”
While Schwab doesn’t raise alerts when customers trade, it has “a robust ETF education offering,” said Erin Montgomery, a spokeswoman. Schwab’s lineup of commission-free ETFs is designed to help investors build long-term holdings, she said.
“All of the ETFs are from well-established providers and we took a close look at AUM, spreads and tracking error when selecting ETFs for the program,” she said. “In addition, Schwab’s trading desk supports advisers and investors with execution of large or more complex ETF trades.”
Cokie Berenyi, whose firm, Red Triangle LLC, in Charleston, South Carolina, manages $40 million, said proper education may be more important than legally mandated fund disclosures, which typically are unhelpful.
“It’s not in plain English,” she said. “It should be understandable, instead of being in language that covers the firm legally.”
State Street Corp., the second-biggest ETF provider, works hard to provide a range of education material to investors directly and to make sure advisers are properly informed, Scott Ebner, global head of ETF product development, said in an interview. He said some responsibility also lies with investors.
“There’s a lot of information out there about the risks of premiums and discounts, and about the risks and opportunities associated with trading in the second market,” he said. “They still have to do the work to understand how it works, how it fits into their portfolio and with their risk preferences.”