This post discusses Net Asset Value (NAV) trading for ETFs and the challenges investors need to be aware of when making NAV trading decisions.

WHAT IS NAV

Net Asset Value (NAV), whether for mutual funds or exchange traded funds, is considered an indicator of the true value of that fund and is one of the most important data points when making investment decisions around a fund.

A fund’s NAV is the sum of all its assets (the value of its holdings in cash, shares, bonds, financial derivatives and other securities) less any liabilities, all divided by the number of shares outstanding. It’s an indication of the fair value of a single share of the fund. It provides investors a reference point around which they can gauge any offers to buy or sell shares of the fund. NAV is an important and useful metric for investors and traders–especially those who are used to using the closing price as a benchmark in the Equities world.

Inspite of the above, NAV has its own pitfalls versus trading the ETF. To understand some of the inadequacies of NAV, let’s first understand how NAV is calculated.

HOW IS NAV DETERMINED

To establish the daily NAV, the fund chooses a specific time every day at which to value its underlying assets. For example, for an equity ETF, the NAV is calculated once all the markets being tracked by the ETF’s underlying assets have closed. For a US-listed ETF that tracks US equities, the NAV calculation is fairly straightforward–the NAV will be calculated as soon as the US equities markets close at 4pm EST. At that time, the closing price of each of the fund’s assets is recorded as an indication of its current value. All these prices are then aggregated to arrive at the value of the fund’s entire portfolio.

ETF NAV

CHALLENGES OF NAV TRADING

  1. Underlying assets trading in a different time zone results in the NAV price getting published 2 or more days after the order is received.
  2. The size of the order could impact the cost of trading.
  3. The direction of the order will impact the cost of trading.
  4. The market-maker’s own position can impact the cost of trading.
  5. Cut off times for trading ETFs vary per ETF, provider and custodian which adds to the cost and efficiency of trading.

Let’s take a few examples. For the sake of simplicity we will concentrate only on (A) above where the underlying assets are equities, trading in different time zones. We illustrate with three examples:

(1) A US/Europe-listed ETF that tracks global stocks (including Asian ones): Things get a little complicated when an ETF tracks a global index whereby the underlying constituents are listed across the US, Europe and Asia. If the ETF is listed on NYSE or Europe, the NAV is not determined until the next day because of the underlying Asian securities in the ETF, and if it is a weekend or a public holiday in any region this would also impact the price being published for a further 1-2 days.

(2) A European-listed ETF that tracks US equities: A European-listed ETF that tracks US Equities, say S&P 500, faces a similar problem. The US markets close at 4pm EST, at which point the fund’s NAV is set. But if the ETF is trading on LSE, the UK market opens at 8am BST (3am EST), at which point the ETF starts trading. The NAV for that ETF is still stale, reflecting prices from the previous evening. The US markets do not open until 9:30am EST, which is six-and-half hours later. Thus in this case as well, the value has changed, but NAV has not, and as a result, NAV is “stale.”

(3) A US-listed ETF tracking European equities:  An ETF that trades on NYSE but tracks the FTSE 100 will hold securities trading on the London Stock Exchange. The London Stock Exchange closes at 11:30 am EST—at which point the fund’s NAV is determined.  However, for another four-and-half hours, the ETF will still be trading on the NYSE. A lot can happen in four-and-half hours that could affect the value of the ETF. However, NAV will remain stationary (because the LSE is closed), and only the ETF will reflect any changes in value over the four-and-half hours. In this case, value has changed, but NAV has not, and as a result, NAV is “stale,” and differences between the ETF’s trading price and its NAV can appear.

NAV trading, in some cases, results in settlement issues especially in negative interest rate countries. In cases where the NAV is not determined until the next day, the Authorized Participant or the Liquidity Provider may not be able to do a creation/redemption with the ETF Issuer and settle the trade (deliver the ETF securities) by the usual settlement cycle of T+3. This results in a settlement “break,” with the institutional client having to pay interest on the cash on their balance sheet.

CONCLUSION/KEY TAKEAWAYS

Savvy investors should be aware of the above pitfalls before making NAV trading decisions. Below are a few key takeaways based on our research and conversations with ETF Liquidity Providers on NAV trading:

  • Liquidity providers usually are willing to provide NAV risk pricing only on large sizes
  • Liquidity providers will incorporate:
    • the cost of trading the underlying
    • stamp duty (if applicable)
    • risk they have to take, especially when the underlying assets are not trading in the same time zone or at a time past cut off
  • In most cases, the final trade price (NAV +/- certain basis points) is not determined until the next day
  • In some cases an ETF’s iNAV (Intraday/Indicative Net Asset Value) could be useful – the iNAV is usually calculated by a third-party commercial vendor and disseminated every 15 seconds by the exchange. They are a useful measure but suffer some of the same pitfalls that NAV face
  • ETF NAVs and iNAVs are calculated in the base (accounting) currency of the fund. If the ETF has underlying assets in different currencies, then one may need to do a currency conversion to determine if a fund is trading at a premium or discount to the NAV/iNAV.

 

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