In search of a bargain

Nick Sudbury assesses how ETF investors can achieve better prices The performance of an ETF is ...

Nick Sudbury assesses how ETF investors can achieve better prices

The performance of an ETF is normally calculated by reference to its NAV or fair value, which reflects both the index return and the tracking error. This provides an objective measure of what the instrument has delivered, but it does not tell the full story. That is because the return for a particular investor depends on how the market price compares to fair value at the point of purchase and sale.

Those who buy and sell ETFs do so at the prevailing bid and offer rather than the underlying NAV (net asset value). This means that the investment return will be affected by the premium or discount when acquiring and disposing of the holding, as well as any fluctuation in the market bid-offer spread. Both of these elements could potentially have a significant impact, which suggests that investors who are familiar with the pricing process may be able to improve their performance.

The primary market
The creation and redemption process is done in large size orders via authorised participants such as brokers and market makers. These organisations would normally create shares in a traditional ETF ─ that invests in the underlying stocks ─ by delivering the constituent securities in the correct weightings to the fund's transfer agent. Redemptions work the other way round, with both involving a back-office process where the basket of stocks is swapped for shares in the ETF.

"With liquid indices of less than 100 stocks, this sort of in-kind transfer is relatively straightforward, but it becomes quite intensive for more exotic areas like emerging markets," said Manooj Mistry, head of db x-trackers UK. "That is why some providers would allow the purchase to take place in cash and then enact a programme trade."

The process is similar for swap-based ETFs except that there is an intermediary, normally the swap counterparty. This central market-maker receives all the creation and redemption instructions and nets them off so that the operation of the swap becomes easier, with possibly just the one adjustment required each day.

Whenever the price of an ETF moves away from its NAV, it creates an opportunity for an authorised participant to make a risk-free profit by creating or redeeming shares in the fund. For example, if a product was trading at a premium, an arbitrageur could buy the underlying stocks and exchange them for shares in the ETF that it could then sell at a profit. This would have the effect of driving down the price towards fair value.

"A key determinant of the liquidity of an ETF is the liquidity of the underlying basket of stocks," said Mistry. "This means that the typical gap between NAV and market price will vary from one ETF to another depending on the normal bid-offer spreads in the secondary market and the costs of the creation/redemption process, which are higher when dealing with more exotic indices."

The mechanics of the primary market suggest that the average discount/premium to NAV would tend to be wider on those funds that track broad or illiquid indices. This implies that it may be possible for sophisticated investors to use the daily NAV and the subsequent intraday moves in the index to calculate a proxy fair value so as to identify the opportune time to trade.

"There is a good chance that investors may be able to arbitrage some of the emerging market funds, as products like the Brazil ETFs can trade 5% either side of fair value, but it shouldn't be possible to do this on funds such as the iShares FTSE 100," said Mick Gilligan, head of research at Killik & Co.

When funds like iShares MSCI Brazil open in London in the morning, the underlying market is closed so the prices will tend to reflect what is happening to the S&P 500 futures which are used as a proxy. Investors in the ETF will need to be mindful of the spread, but it should still be possible to take advantage of any discount below the previous night's NAV, although adjusting for the exchange rate makes the calculation quite complex.

Pricing anomalies also occur in some of the most liquid ETFs. For example, the S&P 500 SPDR that is listed in the US sometimes trades at a small premium or discount to NAV and those who monitor the situation may be able to take advantage of this mispricing.

Secondary market pricing
It would be logical to expect the gap between the mid-price of the ETF and the NAV of its underlying portfolio to fluctuate more widely in volatile conditions. This would affect how closely the investment return mirrors the benchmark over short periods of time. In December, for example, when the FTSE 100 was typically closing up or down more than 2% there were several days when the return from the ETF was noticeably wide of the mark. There were even occasions when the index fell yet the associated short ETF lost value.

"Sometimes it's possible that a rogue price on an ETF, such as a mispriced order near to the end of the day, can throw the closing price of the fund," said Mistry. "Where this is the case it can distort what is shown as the change in price on the following day."

Generally the best way to try to capitalise on these sorts of pricing anomalies is during the opening or closing auctions on the LSE. Investors with direct market access are able to use these short periods at the start and end of the day to enter orders onto the exchange. The LSE then runs an algorithm that finds the single price for each share that crosses the maximum volume of buys and sells. This is normally taken to be the official opening or closing price for the day.

"The auctions are often the most efficient time of the day as there can be a large number of buyers and sellers," said Gary Duckworth, business development manager at iDealing.com. "There are no pricing anomalies on the iShares FTSE 100 because it's so liquid, but in some of the other ETFs it's sometimes possible to use the opening auction to get a 4% improvement on the previous night's close."

Those with direct market access can enter limit and market orders into the auctions. The former offer greater protection as they can never be triggered at an inferior price, although the investor runs the risk that if they are outside of the level determined by the crossing algorithm they will go unexecuted. By contrast, a market order is guaranteed to go through as long as there are orders on the other side of the book for it to trade against.

"Occasionally the auction may be skewed by a large market order to trade a much greater size than is on the other side of the book," said Duckworth. "In order to complete that order, it may have to execute against four or five smaller limit orders at an inferior price. This is then the single uncrossing price at which all the trades in the ETF go through."

Investors who monitor the opening auctions may be able to spot these imbalances and take advantage by using a limit order to trade against the large market order. This could enable them to get a highly favourable fill relative to the previous night's NAV.

Bid-offer spreads
The other important issue that ETF investors need to take into account is whether they can refine the timing of their trades to benefit from tighter bid-offer spreads. Research from Killik & Co suggests that the potential saving could be quite significant. The firm analysed the situation by taking snapshots of the market spreads of all London-listed ETFs at five minute intervals over a two and a half hour period on January 7th.

Table 1 shows the results for those funds that track the UK equity indices. Perhaps the most noticeable point to emerge is that the average spreads vary from 9 basis points up to 115. As would be expected, this tends to reflect the respective trading volumes and suggests that it is much cheaper to invest in the more liquid instruments like the iShares FTSE 100.

"Liquidity is the biggest determinant of the spread but there are other factors to take into account such as the assets under management," said Gilligan. "The iShares FTSE 100 is the benchmark in London as it's the most liquid ETF, invests in liquid underlying securities, only trades when the London market is open and has strong daily trading volumes."

Table 2 summarises the results across each of the main international equity regions and includes the fixed income ETFs as a point of reference. The Asian and emerging market products have the highest average spreads, which implies that these are consistently the most expensive areas to trade. It is also noticeable that each region exhibits quite a sizeable difference between the minimum and maximum spreads. This suggests that those who are prepared to refine the timing of their trades may be able to save some money.

Tables based on information provided by Killik & Co
*Avg Bid-Ask spread calculated as an average of snapshot spreads taken every 5 minutes between 11.18 - 13.48 GMT
**AUM (assets under management) snapshot as of 7/01/2009. Source: Bloomberg.

"The spreads on some of the agricultural ETFs tend to be narrower in the afternoon when the underlying futures are traded, so those who want to buy or sell them should wait until then," said Gilligan. "The Far Eastern funds such as iShares MSCI Japan will also tend to be run against the futures contract as the underlying market is closed when London is open. Where there are no futures the spreads tend to vary dramatically, which is why funds like db x-trackers FTSE Vietnam are more suited to longer-term investors."