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.