Few Worries over NAV and Bid-Ask Spreads

Posted 06/19/2009, 12:00 am EST by Will McClatchy from ETFzone.com

If you see an exchange-traded fund (ETFs) trading at a significant premium/discount to net asset value (NAV), this is not necessarily a case of inefficiency. With small capitalization and international equities especially, this is to be expected.

Consider an ETF trading in the U.S. that represents an index for a country on the other side of the world. The U.S. exchange trading the ETF is open while the exchange trading the underlying stocks is closed. The official end-of-day NAV is many hours old and may reflect yesterday's news, while the ETF trades actively and reflects today's news. Which is going to be a more accurate reflection of the value of the underlying stocks? We would put our money on the ETF.

A similar situation occurs with a U.S. ETF replicating U.S. small cap stocks. Both types of instruments trade during the same hours, but they certainly don't all trade as frequently. Many small stocks have relatively few interested investors and trades are sometimes separated by hours, so that NAV figures - on average - represent relatively old information. ETFs, on the other hand, tend to trade by the minute, if not the second. Bid and ask prices of the small stocks tell more about where the next trade is likely to take place than the last small stock trades used to construct official NAV figures.

Bid-ask spreads of ETFs, which represent a loss to the investor, vary widely but are generally fair. In big, highly traded ETFs they are miniscule, a penny or two at most. In small, thinly traded ETFs they are substantial, five or ten cents or more. But in almost all cases, investors would be worse off buying the underlying securities because the average spread is typically greater than in the ETF representing them. A little noticed fact is that ETFs get around the individual security bid-ask problem during their creation. A basket of securities is traded for the ETF which represents that basket, and then vice versa when the ETF is redeemed.

Studies show that ETF trading prices stray very little from the mid-point of what sellers ask and buyers bid. The midpoint has no magical meaning, but seems like a sensible spot to locate fair pricing in absence of recent actual trades. As expected, the variation around that midpoint is higher for small cap and sector ETFs with lower trading volumes.

Co-founder of indexfunds.com, author of two books on investing, and founder of ETFzone.com, Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.