ETF Premiums: No Worry—Until They Bite
November 14, 2012
Big flows recently out of junk bond funds like HYG point to lessons on how not to trade ETFs.
Headlines today focused on big outflows from the iShares iBoxx High Yield Bond ETF (NYSEArca: HYG). But the real story was the object lesson on how terrible ETF trading can cost you big, big money.
It’s axiomatic in ETFs that everyone wants a fair deal. It’s axiomatic in life really. Nobody ever wants to pay too much when they’re buying something, or get too little when they’re selling.
With most ETFs, this is never an issue. A fund like the SPDR S&P 500 ETF (NYSEArca: SPY) trades within a penny of the fair value of its underlying stocks—day in; day out; all day; every day.
The reason this is so is because of the creation/redemption process. If investors buy a lot of SPY, driving the price up over its fair value, authorized participants swoop in and arbitrage-out the price difference, creating new shares of SPY to sell, while buying up the underlying stocks of the S&P 500 Index. This helps depress SPY’s price while simultaneously supporting the prices of the underlying stocks.
And because it works so well so much of the time, I generally tell folks not to stress too much about premiums and discounts. But there are two cases where you can learn a lot—and potentially save some money—by paying attention.
First, let’s take the case of international funds. Most international ETFs will show a measurable premium or discount on any given day because they trade while their underlying securities are done changing hands for the day.
That means the net asset value (NAV) is “stale” at 4 p.m., while the market price is “live.” Such is the case with iShares’ popular EAFE ETF, the iShares MSCI EAFE Index Fund (NYSEArca: EFA).
You can see here that for most of the 2009-2010 period, the fund traded at mean-reverting—effectively random—premiums and discounts.
But note the big discount-to-premium swing in November 2011. That corresponds to the blue line on the chart, which maps shares outstanding.
Changes in shares outstanding mean one of two things—either APs are responding to premiums and discounts, or large investors are buying big, negotiated blocks of shares.
In this case, my suspicion is the latter—a large investor came in and bought a huge chunk of EFA, effectively adding to inventory. In response, for a period of a few days, there was a perception of a “glut” of EFA shares; in effect, causing the short-term discount. That discount then evaporated with the resumption of normal trading.
In general, however, I discourage folks from speculating too much on single-day reports of creations and redemptions—the data are noisy, and are often corrected after the fact. And of course, it’s impossible to know whether creations are proactive—an ETF investor calls an AP and asks for 200,000 shares for a major position, at a negotiated price; or reactive—an AP sees an arbitrage opportunity and jumps.
With that in mind, let’s compare what happened with EFA to another fund tracking the exact same index, the Vanguard MSCI EAFE ETF (NYSEArca: VEA).