ETF Asset Values Separating Fact And Fiction

Posted By: Rupert Hargreaves

The rapid rise of the ETF industry over the past two decades has been nothing short of astounding. Since the launch of the SPDR S&P 500 ETF (SPY) during 1993, more than 1,600 ETFs have hit the market, covering a broad range of assets and strategies.

The value of assets being managed by the ETF industry has expanded nearly 2,000% since 2001, eclipsing the growth of the mutual fund industry over the same period (+120% AUM). That said, the size of the ETF industry is still relatively small compared to the mutual fund industry. Mutual funds manage a combined $15.9 trillion of assets, compared to ETFs $2.9 trillion of AUM.

But the complexity of the exchange-traded product market seems to be holding the industry back from expanding further. According to a survey conducted by etfdb.com when quizzed as to why they didn't use ETPs, around half of the advisors questioned stated that they didn't know enough about the products to recommend them to clients. Recent ETP market developments are likely to have only increased this sentiment.

 

ETFs: Growing asset class

ETF's: Separating fact and fiction

At the end of August, Bank of New York Mellon revealed that it had been unable to produce correctly ETF and mutual fund valuations due to a computer glitch that occurred during the market turmoil at the end of last month.

The issue affected 20 mutual fund firms and 26 families of ETFs, which together account for about 10% of US funds (not all used the damaged system). The PowerShares China ETF was one of the most affected instruments; its published a net asset value that was off by 2.5%.

BNY Mellon's ETF debacle highlighted the risks of ETFs, or more specifically, the danger of relying on an often misleading underlying NAV to value ETFs.

Even ETF has a custodian, which holds all the assets of the fund and records any liabilities. And while the custodian holds the assets, it's the job of the fund accountant to keep track of expenses, the fund's NAV and dividends received. Many custodians do the accounting themselves using proprietary software and dedicated employees. Some outsource it or use third-party software vendors.

When it comes to defining the word "asset" for funds, there is a great deal of confusion. The fund industry is governed by the Investment Company Act of 1940 and this act requires that portfolio changes "shall be reflected no later than in the first calculation on the first business day following the trade date."

Unfortunately, this means that in today's fast moving market, investors can be forced to wait a whole day before finding out what's actually in the fund's portfolio. If managers decided to swap a stock on Monday, it wouldn't show up in the fund's NAV until Tuesday, which would mean that Monday's NAV figures are complete fiction. It could be said that the NAV of a fund on a day that involved a single portfolio transaction is a fiction.

 

Total ETF Flows

Unreliable NAVs can, and do, distort ETF values. A 2006 research paper titled, Live Prices and Stale Quantities: T+1 Accounting and Mutual Fund Mispricing looked into the problem of delayed reporting, finding that it has become a serious challenge for the industry:

"While stale prices may plague a few types of funds’ NAVs, there is a far more common and insidious problem that has avoided public notice. Normal mutual fund accounting, sometimes called “Trade Day Plus One” or “T+1” accounting, always uses stale portfolio information in the calculation of NAVs. In the simplest terms, in calculating today’s NAV, fund pricing services use today’s prices applied to yesterday’s portfolio, i.e., live prices and stale quantities. Securities bought or sold on date t do not show up in the NAV on date t rather the calculations are done as if no portfolio trading took place during the day. This set of accounting rules, which is used by virtually all U.S. mutual funds, drives a wedge between the reported “Accounting” NAVs used to calculate the prices at which funds are bought and sold and the actual “Economic” NAVs which represent the value of the funds’ portfolios."

ETFs: Asset value

Another problem arises when it comes to the question of calculating the actual value of assets held by the ETF.

As factset.com points out, every firm has its own set of rules for computing underlying ETF asset values. Occasionally, the difference in the recorded price between two firms for the same asset is enormous:

"Vanguard, for example, uses a “fair value” for stocks in, say, Japan. So if Japanese futures and U.S.-listed Japanese stocks rally like crazy during U.S. market hours, they will use a formula to adjust last night’s closing prices for Japan to reflect the new information. For ETF investors, it’s normal for a fair-valued ETF to look like its trading closer to fair value than a non-fair-valued NAV, but your actual holdings can be identical."

These factors make it difficult for an ETF investor to rely on published NAVs. As a result, ETF investors shouldn't be overly concerned about ETF NAVs. The most important thing for an ETF investor is the price the instrument is trading at. NAVs should only be used as a guide to help assess whether or not you're getting a good deal.

These rules only apply to unleveraged stock and some bond ETFs. Levered instruments and commodity ETFs should be classified as a whole different asset class entirely.