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Last week, volatility in the financial markets caused an unusual situation, where the prices of some exchange traded funds (ETFs) traded at either a discount or premium to their net asset values (NAVs).
This lead some of our readers to ask if this was perhaps an arbitrage opportunity. In a word – no. Only because that would need a sudden purchase, when individual investors should always stick to their plan and asset allocation strategy for the best long term results.
Individual investors should always stick to their financial plan, and asset allocation strategy, which in turn should be based only on your risk appetite and financial goals.
Having said that, the phenomenon of discounts (and premiums) with bond ETFs do happen. Why? Let's explore what the disconnect between ETF prices and NAVs means.
As Ben Johnson, Morningstar’s director of global ETF research explains, “These episodic dislocations are a feature of ETFs, not a bug. These circumstances create opportunities for ETF market makers to profit from bringing ETFs’ prices back in line with their NAVs. During the week of March 23, the prices and NAVs for many of the ETFs that saw the most extreme discounts were again reunited. As of March 25, things were mostly back to normal, as shown in Exhibit 1.”
“ETFs’ NAVs are all stale--to varying degrees. Each and every tick in the fund share prices aren’t synced with a tick in each and every one of the securities in its portfolio. These mismatches vary depending on what’s in the fund,” Johnson notes.
Bonds are not stocks
Mario Cianfarani, Head of Institutional Sales and Retirement for Vanguard Canada, explained that this disparity was seen with fixed income ETFs, mainly because the ETFs trade in real time, faster than the underlying assets. Bonds don’t trade like stocks, and usually trade slower. So unlike a NAV that’s calculated by a pricing provider, market prices for bond ETFs reflect the market’s minute-by-minute judgment, leading to discounts and premiums.
Johnson notes that the bond market closes an hour earlier than the stock market. Closing prices for bond ETFs are set an hour after the values for the bonds they hold are struck--the values baked into their end-of-day NAV. This mismatch explains a portion of the structural (that is, persistent and readily explainable) premiums and discounts we see among bond ETFs.
“That said, they are a somewhat blunt instrument to the extent that their prices are more an expression of the market’s top-down view of the value of the basket of bonds they represent than a bottom-up bond-by-bond valuation exercise that takes place once a millisecond,” Jonson explains.
Some of the factors that affect prices include valuation estimates, supply and demand for the ETFs and the cost for providing liquidity. These disparities usually don’t last very long – things returned to “normal” in two days, as we saw. As Vanguard explains with this chart, over the long term, bond price premiums and discounts have been small.
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