The ETF’s Price is Right—except when it’s not

Last week I described how an ETF’s market price and net asset value (NAV) can diverge. Now it’s time to look at the three main reasons why this occurs. Our guides for this discussion—which I’ll warn you is quite technical—are Pat Chiefalo, director of ETF research and strategy for National Bank Financial, and Steven Leong, vice-president at BlackRock Asset Management, provider of iShares ETFs.

1. The ETF has low trading volume. In most cases, low trading volume is not a major concern with ETFs. However, thinly traded funds are more likely to display short-term differences between their market price and their NAV.

Official end-of-day prices on the TSX are based on the last board lot to be traded in a single order. There may be some days when all the orders for an ETF are less than 100 shares. “In that case, there would actually be no official end-of-day price, even though there were transactions,” says Steven Leong. “Less extreme would be a case where the last board lot traded at 1:30 in the afternoon and the market moved on from there.” When the NAV is calculated at 4 pm that day, it would be quite different from the last transacted price, which is now two-and-a-half hours old.

This is also why you should always ignore the “last” price in an ETF quote. When you place a limit order to buy, use the ask price as your reference point. If you’re selling, base your limit order on the bid price. “It’s frankly unnatural for us to consider the last price as the benchmark for an ETF trade,” Leong says, “although I know a lot of people grow up trading like that.”

2. The underlying securities are illiquid. Sometimes the issue is not that the ETF is thinly traded: it’s that its underlying holdings are illiquid. “You can get into a situation where the prices of the stocks and bonds used to calculate the NAV are stale,” says Pat Chiefalo. “If a stock, or a preferred, or a bond has not traded in a few days, the net asset value will tend to keep the price of the last trade.” In this scenario, it’s the market price, not the NAV, that is likely to reflect the true value of the ETF’s holdings.

Leong says this is most likely to happen with fixed income ETFs, because bonds are traded over the counter. “Determining the NAV is based on a series of rules and a third-party pricing source,” he says. However, Leong says this only happens when an ETF’s trading volume is dramatically higher than that of the bonds themselves, and that rarely occurs in Canada. “It is certainly a phenomenon that can happen with a handful of US ETFs, but I’m not sure it’s terribly prevalent here.”

3. Time zone differences. International equity ETFs hold stocks that are traded in European and Asian markets, which are usually closed when North American exchanges are open. (London and continental Europe markets overlap briefly with Toronto and New York.) So when market makers are posting live bid and ask prices for those ETFs, the prices of the underlying securities are likely to be stale because their home markets are closed.

Chiefalo explains the market makers may use American Depositary Receipts as proxies (ADRs trade in New York and represent the shares of overseas companies.) “But when the underlying basket has very few ADRs, then the traders make their best estimate. So if there is a lot of market movement compared to the previous day, the NAV and market price are going to be very different. The price is actually going to reflect a fairer value than a stale NAV from the night before.”

These time zone differences can also cause an international ETF’s tracking error to appear unusually large, an issue I wrote about in an earlier post. For a more up-to-date discussion, see this recent article from Vanguard.

Which price is right?

So if you want to know how your ETF is performing, should you look at the market price or the NAV? “I don’t know if there is one universal way to do it,” Chiefalo admits. “I think by default people go to the NAV, but you should appreciate that discrepancies may happen and it may not necessarily indicate something is wrong.”

Leong agrees there’s no easy answer. “You shouldn’t look at one number and ignore the other: they are both part of the story. If you’re a long-term investor, the NAV is really the right thing to look at, because that is showing you how the economic value of the portfolio is changing. But the specific prices you transact at are going to dictate your own performance.”

If you’re holding your ETFs for the long haul, it ultimately makes little difference which performance number you use for individual calendar years. But you should follow some simple rules whenever you trade:

• Always use limit orders: no exceptions. Ignore the last price and place your order within a couple of cents of the bid (if you’re selling) or ask (if you’re buying).

• Don’t place an order during the first few minutes or last few minutes of the trading day: differences between price and NAV are likely to be widest at these times. And never place a limit order during off-market hours expecting it to be filled at the market open.

• If you’re making a large trade in an international equity ETF, consider placing the order before 10:30 am EST, while the European markets are open and price/NAV discrepancies are likely to be lowest.