October 2010

ETF RISK: catch the drift

Drift_fishingETFs are not bought and sold on the same basis as index-tracking funds. Felix Goltz and Lin Tang of EDHEC look at pricing and performance Although exchange-traded funds (ETFs) are designed to track an index passively and provide exposure to its risk and performance features, ETFs that for legal reasons cannot fully replicate an index need to be managed more actively. Any deviation of an ETF’s returns from the underlying index returns results in a performance gap. Unlike index funds, which can be bought and sold only at their daily net asset value (NAV), ETFs can be exchanged in secondary markets at ask/bid prices that may differ from their NAV.

Therefore, based on research carried out as part of the ‘Core-Satellite and ETF Investment’ research chair, sponsored by Amundi ETF, we are looking this month at the pricing and performance of ETFs.

For an investor, the total performance shortfall (or gain) is the right measure with which to identify the gap between the performance of the ETF and that of its underlying index. This gap should be measured as the return difference between the underlying index and the ETF – taking into account the investor’s actual buying price. This price, however, is not easy to obtain, and might require studying specific transactions to take into consideration the specific market impact of such trades. The total performance shortfall can be conceived as the sum of the ETF management inefficiencies and market inefficiencies. Since the former lie within the ETF management itself, they can be controlled by the fund management company. The latter are beyond the control of the ETF company, since they depend on the market makers, supply and demand, and transaction costs.

NAV versus market price
An ETF has an NAV calculated with reference to the market value of the securities held. NAV is the total value of the fund after netting the market value of each underlying share in its holdings, cash, accruals, fees, operating costs, and other liabilities and divided by the number of issued shares. For fully replicated index trackers, the NAV should be exactly the same as or very close to the fund’s underlying index value (taking into consideration a multiplier if required).

On exchange, however, the market price of an ETF, like that of a stock, is determined by supply and demand. ETFs are bought and sold at their market prices, which may be at a premium or discount to their NAVs. When the market price of an ETF is not equal to its NAV, arbitrage opportunities are created and the creation and redemption process brings the fund’s market price back to its NAV.

The intraday NAVs of ETFs are also usually calculated every 15 seconds by third-party vendors; the market prices of the underlying index constituents are taken into account so that investors can tell whether the ETF is fairly priced. This intraday NAV, also known as indicative net asset value (iNAV) or indicative optimised portfolio value (IOPV), is different from the daily NAV of the fund, which is computed after the market closes for the day.

In an empirical study, researchers found that in the US ETFs have highly efficient prices, though their conclusions for international ETFs are different. In fact, the authors find that the premiums or discounts on fund NAVs are usually small and disappear very quickly, a disappearance that confirms the view that the creation and redemption mechanism of ETFs effectively limits and destroys arbitrage opportunities.

Performance drift
Ideally, ETFs should derive their value and volatility only from the market movements of the underlying index or market prices of the constituent securities of this index. But perfect replication is not always possible; in fact, performance drift is inevitable. An index portfolio is only a paper portfolio and requires virtually no management, administration, asset buying or selling, custody, and so on. An ETF, by contrast, holds assets physically, manages them, distributes dividends and handles a relationship with investors.

These operations incur costs. So to keep costs down and make sure they are consistent it is necessary to understand the components of these costs. Several costs can be a drag on ETF performance, some related to the direct costs of implementing the strategy, others to the way the index is replicated and exceptions handled.
  • Implementation: ETFs need not replicate indices by buying or selling the underlying securities. They are paper portfolios calculated on the basis of market prices and weightings of their underlying securities. The underlying securities may not be very liquid and, given the large size of an ETF portfolio, the price of a constituent security may go up as a result of high demand during implementation. This cost, also known as portfolio construction/rebalancing cost or transition cost, which also includes the actual transaction costs, results in a performance drag on the ETF portfolio.
  • Management fees and other operational expenses: unlike ETF portfolios, indices do not incur management fees, administrative costs and other operating expenses. Often expressed in terms of total expense ratio as a percentage of the NAV, these costs are deducted from the ETF assets and the daily NAV is affected accordingly (daily accrual). When dividends and interest income are paid, usually every quarter or twice a year, total management expenses are deducted from the payment and the NAV of the ETF returns to the index value.
  • Transaction costs in the secondary market: investors buying or selling ETFs on exchange through their broker must shoulder brokerage commissions, bid/ask spreads, the market impact of a large transaction, stamp duty, transaction levies charged by the exchange, and so on. These costs make ETF returns lower than those of the underlying index.
  • Cash drag: if ETFs pay dividends they usually do so every quarter or twice a year. However, the underlying securities pay dividends sporadically throughout the year. While the index value reflects full dividend reinvestment, an ETF portfolio holds extra cash that has no capital appreciation, no returns. This generates a minor disparity between the ETF portfolio value and the underlying index value. Tracking error caused by this phenomenon is called “cash drag” because the ETF portfolio holds extra cash that drags its performance down.
  • Mispricing costs in secondary markets: an ETF may trade at lower than (at a discount to) its NAV or higher than (at a premium to) its NAV. Factors such as unmatched supply and demand, illiquid underlying securities, and market inefficiency may contribute to the move of trading prices away from NAV. Since ETF shares can be created/redeemed anytime during trading hours by authorised market participants or arbitrageurs, this disparity does not last long. On the other hand, there are also several benefits that may allow an ETF to compensate for replication costs. In some cases an ETF can yield higher returns than the index to be replicated.
  • Securities lending: ETF providers can lend their securities to other market participants and thereby earn lending fees.
  • Tax benefits: in some countries it is possible to partly recover withholding taxes through the purchase of single stocks during the period of dividend payments.
  • Management of index events: intelligent management of index component changes and other events can generate additional returns for the ETF. However, if done unsuccessfully, such management may also lead to underperformance of the index.
The impact of ETFs on price efficiency
Before the introduction of ETFs, index futures were one of the major means of replicating index performance. Futures markets may show slight deviations of the futures price from the fair price reflected by the underlying index value, and these deviations may be caused by transaction costs or market illiquidity.

The difficulties of tracking an index were greatly reduced by the introduction of ETFs. ETFs are traded on exchange like stocks, all while replicating indices in cost- and tax-efficient ways. With the in-kind creation and redemption process, arbitraging trades are much easier to execute and, as a result, the price discrepancy in ETF markets is short lived. As ETFs offer another means of index tracking, a vast body of academic research has looked at the influence of ETFs on the price efficiency in the index spot-futures market. It has been shown that there is a clear price leadership of the ETF market over the spot market, a demonstration that suggests that ETFs process information faster than the spot market.

Researchers found evidence from the Diamonds and the QQQ funds that the liquidity of underlying markets increases after ETFs are introduced. This increased liquidity stems largely from the lower cost of trading. Researchers have also shown that the introduction of ETFs significantly improves price efficiency in the index spot-futures market. Market responses to observed price deviations are also swifter in periods during which there is an ETF on an index than they are in periods before the existence of the ETF. A further paper recently showed that a strong two-way causality between futures price efficiency and index stock liquidity appears after the introduction of the ETF.

In summary, the empirical literature finds that the introduction of ETFs offers better opportunities to perform arbitrage. Moreover, it improves the liquidity of the underlying index and reduces price discrepancies in the index spot-futures market.

Felix Goltz, PhD, is head of applied research, and Lin Tang, is a research assistant at the Edhec-Risk Institute

©2010 funds europe

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