From the September 2013 issue of Investment Advisor • Subscribe!

August 26, 2013

Crowdsourced ETF Pricing

Sometimes determining the fair value of a fund is a tricky business

The intraday pricing of international equity ETFs has garnered much recent attention. While some view the divergence between the intraday price of an international ETF and the value of its underlying securities as a form of a premium or discount, this is not the case at all.

Mutual funds help provide an understanding of this anomaly. Many international equity mutual funds run into challenges with daily purchases and redemptions when determining the right value of underlying securities, primarily because the vast majority of those underlying securities are not trading in their home markets at the 4 p.m. Eastern time close of U.S. markets. A mutual fund sponsor is then left to determine the NAV at the best price for both buyers and sellers.

If the U.S. market’s day is uneventful, odds are those underlying holdings are worth approximately the same price as where they closed. If the day is eventful—and these types of days, where the market can move up or down, or both up and down, by 100 basis points in a single day, occur more often than not—the resulting volatility usually spreads into international markets once they open and likely affects the value of those underlying securities.

Fair valuation is the process of trying to determine the correct value of securities. This is an important process, as recently evidenced by the SEC’s investigations regarding how certain mortgage-related securities were valued during the financial crisis. If international markets are expected to drop dramatically the next day (likely due to a fall in U.S. markets), investors may be overpaying for the fund, and redeeming investors will get more money than they should, leaving existing shareholders on the hook.

The fair valuation process works exactly the same way with an ETF, except investors buy and sell at the publicly offered price instead of the NAV. The ETF price is normally in line with its indicative value or estimated NAV. However, during volatile times a price difference becomes evident between the underlying securities’ value at their previous close on the international markets and how they trade in the U.S. market. What influences those changes is the very same cause that impacts the fair value process used to calculate the NAV.

The Important Differences

Multiple market participants usually drive the public offering price for ETFs. When the intraday fair valuation process takes place, a wide variety of views determine the expected value of a given securities basket and investors select the best price for both purchasing and selling ETFs, whereas in a mutual fund, the fund sponsor solely determines the valuation.

The other notable difference is that investors can see when the public price for an ETF is diverging from the last international market trading value, so it is much more obvious when fair valuation is affecting the price. How does a mutual fund determine fair valuation? Very little information is available to help investors understand the price they may receive on an adjusted trading day. Although a prospectus mentions that the mutual fund sponsor has the right to make fair valuation adjustment, there is no specific obligation when to tell investors.

The transparency that ETFs provide in this process is critical for investors and helps advisors know that transparency means far more than just holdings for their clients.

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