Sometimes it takes a big flashlight to illuminate something as murky as ETF spreads.
It's not often I toot the IndexUniverse.com horn. To be honest, it's a lot more fun disagreeing with Matt every week. But I just had the opportunity to read, with a cold, calm eye, "Understanding Bond ETF Premiums And Discounts," and it made me grin from ear to ear.
I'll let you read the article for yourself, but there's one point I wanted to dig into, just a bit.
This one figure does more to explain how ETFs really work than pretty much any graphic I think I've ever seen, and it's certainly better than any similar versions I've tried to come up with on my own. While this was designed as a framework for bond ETFs, it really does perfectly communicate half a dozen key points about ETFs so many folks fail to grasp. In brief:
NAVs aren't a magical fair market value, as much as that would be useful. In the bond space, as the chart shows, it's based on the bid price of every bond in the portfolio, a literal "what would I get if I had to dump all these bonds?" But every fund has its own way of calculating NAV, and often, it's even a bit vague what that is. Here's how, for example, the United States Oil Fund (NYSEArca: USO) says it comes up with NAV: ETF holdings are ""¦ valued by the Administrator, using rates and points received from client-approved third-party vendors (such as Reuters and WM Company) and advisor quotes." Have fun reverse-engineering that. The "true" value of the holdings of an ETF is quite fuzzy. The full width of the bar"”the total discrepancy between the portfolio's bid and the portfolio's offer"”can be quite large. In fact, it can be larger than this band, because those bids and offers are all at once, irrespective of size, or of the information impact of someone coming into the market to buy or sell a large position of the entire index. As the article points out, in bonds, that can run as high as a few percent. ETFs almost always trade inside the underlying market. While we can sit around and be technical all we want about arbitrage and such, I have to admit every time I think about it anew, I'm just stunned by this fact. It's really one of the only free lunches in investment management history. OK, not entirely free, as you'll pay some basis points over time to own an ETF, but from a trading perspective, ETFs in illiquid markets like high-yield bonds have made some very fine purses out of smelly pig parts day in and day out for years.
Perhaps even better is how the following chart changes when you get to an ETF discount situation.
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