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
It's axiomatic in
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
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 (
) 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).
Two things are going on in this ETF that make it vastly
different than its kissing cousin, EFA.
The first is that Vanguard "fair-values" its NAV at the end of
the day. That means that instead of relying on the closing price of
Toyota Motor Corp in Japan, Vanguard revalues the stock based on
how proxies-futures and American depositary receipts-have traded
during the U.S. trading session. This serves to remove most of the
noise from the chart. Gone is the random mean reversion.
What then explains the slight, but persistent, premium here? The
blue line again represents shares outstanding. For most of this
three-year period, VEA has been steadily gaining assets. In periods
of slight decline or flat growth like in the fall of 2011, the
premium disappears or swings to discounts.
But in general, this is the story of slow, steady buying
pressure keeping the price of the ETF in the open market just a bit
above fair value. And, as long as this kind of premium persists,
the changes are reasonable, so you shouldn't care too much. Someone
in this period most likely bought when the fund was at a premium of
20 basis points or so, and would probably have sold at a similar
But "probably" can really bite you in the you-know-what, as
investors in the iShares iBoxx High Yield Bond Fund ETF might have
discovered in the last few days.
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