Emerging Market ETFs Traded Reliably During Selloff. But What about their NAV Disconnects?

 

February 28, 2018 [Emerging Markets, EFT, Market Volatility]
Charles Roth


EM ETFs suffered deviations in their market prices relative to their net asset values, with their total returns materially underperforming the broad emerging market index.

The early February bout of market volatility nicely illustrates a few points about exchange traded funds. The widely noted first is that big, broad market ETFs proved their trading resilience amid the selloff, as U.S., international, global, and emerging market benchmarks dropped to, or near, correction levels. The less-appreciated second is that investors who traded in and especially out of some types of ETFs, particularly those with somewhat less liquid underlying constituents or more affected by stale constituent pricing, suffered degrees of divergence between the market price of the ETF and its net asset value (NAV).

That divergence can make a significant difference in investor returns. As Thornburg’s CEO and Portfolio Manager Jason Brady had noted in a recent Q&A, during market selloffs “it’s not that the ETF structure will break down;” rather, they may not trade at what people think “the actual value would be…but you could still trade them.” That was true of U.S.-focused fixed income ETFs during the 2008 financial crisis. It was true of country-focused ETFs during the political and economic crises in Egypt and Greece in 2011 and 2015, respectively, when local stock exchanges shut down, disrupting the creation/redemption mechanism for ETF creation units, even as the two ETFs continued to trade.

And it was also true for emerging market ETFs during the most recent selloff. Take the three largest, the Vanguard FTSE Emerging Markets Fund (VWO), the iShares Core MSCI Emerging Markets Fund (IEMG), and iShares MSCI Emerging Markets Fund (EEM), each of which holds tens of billions of dollars in assets. At the end of 2017, the number of holdings in each ranged from 860 in the case of EEM to 4,734 in that of VWO.1 They are classified as broad-market or large-cap ETFs, but include a number of mid-cap stocks, so liquidity of the underlying holdings is generally good.

But as the underlying holdings are based in numerous time zones the world over, these ETFs may be subject to stale pricing, with NAV pricing methodology determined by fair-value or the close of the primary market. When markets turn volatile and trading activity spikes, they can experience disconnects between their market price and their NAVs, or their daily per share value based on trading session closing prices of their underlying constituents. This is easily seen in the recent swings between the NAV of EEM and its market price, which twice traded at meaningful discounts to NAV early in the month and then at a premium in much of mid-February.

 

Market Price and NAV Disconnect

Source: Bloomberg

Unsurprisingly, as volatility kicked in and EEM’s market price tumbled in late January and early February, the ETF’s average bid-ask spread in percentage terms spiked as its trading volume jumped.

 

Bid-Ask Spread Widens as Trade Volume Jumps

Source: Bloomberg

Quite apart from the impact of stale pricing in an ETF’s underlying constituents, trading activity around most ETFs can become extraordinarily heavy, as ETF sponsors and authorized participants work to match changes in the index portfolio, which don’t sustain transaction costs. But ETFs do, from bid-ask spreads, to brokerage commissions, taxes, etc. Such “hidden” costs are often larger than people may realize. For example, the total value2 of EEM’s shares traded over the month from January 19 to February 22 amounted to $107 billion, or nearly 150% of its roughly $43 billion market cap. By comparison, the total value of Apple shares traded in the same period was roughly $180 billion, or about 20% of its market cap.

The bottom line for investors is that ETFs are liquid, but not always at prices reflective of their NAVs, particularly when markets get bumpy. As Brady points out, “You’ll be able to sell it…but not necessarily at the price you think.” Those who sell when volatility sets in may end up locking in more losses than an ETF’s NAV would imply. Potentially significantly more, depending on when they bought it. Although return lags between the big EM ETFs and the indexes can be material over longer periods, short-term traders should be particularly vigilant, as the total returns of EEM, VWO, and IEMG from January 22 of this year to February 5 versus that of the MSCI EM Index and the MSCI Emerging Net Total Return USD Index demonstrate. 3

 

Gaps in Total Return

Source: Bloomberg

The arbitrage function of the ETF share block creation/redemption mechanism generally works just fine. But it’s not a silver bullet, particularly when it involves underlying constituents in different time zones, and liquidity stresses rise when sellers outnumber buyers as markets fall.

 

 

Performance as of 12/31/2017

  Name 1-YR 3-YR 5-YR 10-YR Since Inception
  Vanguard FTSE Emerging Markets ETF (VWO) Incp. 3/4/05 Expense Ratio 0.14%
  NAV 31.38% 7.52% 3.50% 1.29% 7.37%
  Market Price 31.48% 7.51% 3.36% 1.31% 7.37%
  MSCI Emerging Markets Index 37.77% 9.56% 4.75% 2.13% 8.32%
 
  iShares Core MSCI Emerging Markets ETF (IEMG) Incp. 10/18/12 Expense Ratio 0.14%
  NAV 36.78% 9.02% 4.43% n/a 5.15%
  Market Price 37.35% 9.08% 4.02% n/a 5.16%
  MSCI Emerging Markets Index 37.77% 9.56% 4.75% 2.13% 5.76%
 
  iShares MSCI Emerging Markets ETF (EEM) Incp. 4/7/03 Expense Ratio 0.69%
  NAV 36.42% 8.44% 3.72% 1.30% 12.12%
  Market Price 37.18% 8.45% 3.37% 1.39% 12.12%
  MSCI Emerging Markets Index 37.77% 9.56% 4.75% 2.13% 13.35%

Source: Bloomberg, Gross Index Returns.


Annualized for periods longer than one year.

Performance data shown represents past performance and is no guarantee of future results. Investment return and principal value will fluctuate so shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than quoted. For performance current to the most recent month end, please contact your financial advisor or visit ishares.com or vanguard.com.

Market returns are based on the midpoint of the bid/ask spread at 4 p.m. ET and do not represent the returns an investor would receive if shares were traded at other times.

ETFs selected represent three most popular in category based on total assets.

 

1. Index replication strategies vary from full replication for VWO to representative sampling or optimization, in the case of EEM and IEMG. Fixed income ETFs overwhelmingly employ sampling strategies given the high number of bonds in underlying indices that trade infrequently.

2. Defined as the “total amount traded in the security’s currency. This value represents all trade prices, multiplied by the number of shares relating to each price. This value is then summed.” -Bloomberg

3.The stated indexes of the three: VWO, FTSE Emerging Markets All Cap China A Inclusion Net Tax (US RIC) Index (FQEACR); IEMG MSCI EM Emerging Markets IMI USD Net (MIMUEMRN); EEM, MSCI Emerging Net Total Return USD Index (NDUEEGF).

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