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Posted by on Jun 24, 2013 in Investment Perspective

About that EEM Discount

An interesting story published last week on the Barron’s website that warned the risk of ETFs trading at a premium or at a discount in highly volatile markets, highlighting the iShares MSCI Emerging Markets Index Fund (Ticker: EEM) as the primary example.

You may read more here,, but we would counter that the EEM example is neither a premium nor a discount, but in fact represents the best estimate of the value of the underlying securities. What do we mean? It is best to start with an understanding of how international ETFs like EEM work. Obviously the ETF invests in foreign securities, and most of the time, those foreign securities are not trading during the US market trading hours.

There are really only two ways to estimate the value of the underlying international securities. One is checking the prior closing prices of those foreign securities, and the other is to look at the increase or decrease of the value in the US market (or applicable sector). With the volatility witnessed last week, we should fully expect to see foreign markets react to the movement of the stock market. The challenge this creates for both an ETF and a mutual fund, is ensuring that investors (buyers and sellers) get the right price for the value of securities they are buying or selling. If a mutual fund holder seeks an execution price at 4:00 pm, how is the mutual fund company supposed to know the true value of the securities until the foreign markets open, usually well after the US 4:00 pm ET close?

Here is what can happen in the mutual fund scenario.

For this example, let’s assume there is one redeeming mutual fund shareholder in the amount of $10 million dollars and the US markets are down 2% today. The mutual fund does not know what the value of the underlying foreign securities are, but will rather have to guess (meaning provide their own fair value estimate). All mutual funds have some policy for when and how fair value is determined, but it varies from mutual fund to mutual fund. So let’s say the mutual fund decides to fair value the NAV down by 2%. That is a reasonable thing to do and it protects the long-term shareholders, but how does it do that? Well, let’s assume that mutual fund has $100M in AUM. If the mutual fund met a redemption for $10M and the next day sold 10% of the securities, but in the foreign markets only received $8M, the mutual fund would then need to sell more securities (owned by the remaining shareholders) to get the additional $2M. The long-term shareholder would bear the costs of not fair valuing. However, this is a good and smart mutual fund company that has fair value-discounted the NAV to protect the long-term shareholder. Although that does not mean the mutual fund company is penalizing the redeeming shareholder. In fact, the fund company is trying to give that shareholder the true value of those underlying foreign securities. This is a good outcome for all mutual fund shareholders, except for one big (non-transparent) issue. Does anyone really know when a mutual fund fair values the NAV? Do funds report a non-fair value NAV and a fair value NAV? No, (at least now that we know of). Why not disclose this information? The mutual fund company is ultimately trying to do the right thing, but it’s just that investors do not know when or how much their execution price will be affected by this process.

What if the international markets open down 3% instead of 2%? Well in that scenario, the loss will be borne across the remaining shareholders and the redeeming shareholders will receive more than what they should have. What if the international markets only open down 1%? The remaining shareholders then benefit, and the redeeming shareholder sold at a discount. Does anyone ever know when this happens? No.

To assist combating anyone who might try to take advantage of this situation, many mutual funds have implemented exchange/redemption limitations (usually 4 times a year), and short-term redemptions. But those policies are indiscriminate, impacting those who would take advantage and those who just need to redeem.

Would anyone take advantage of this structure? 2003 seems so long ago, but this structural inefficiency is exactly what people were taking advantage of in mutual funds. Recall this Business Week article——here is an excerpt:

Well, let’s take the Imaginary International Stock mutual fund. One day, U.S. markets get a huge boost thanks to positive economic news and the benchmark Standard & Poor’s 500 rises 5%. The market-timer steps in and buys shares of the international fund at an NAV of $15 at 4 p.m., knowing that about 75% of the time, international markets will follow what happened in the U.S. the previous trading day. Predictably, most of the time, the international fund rises in price the next day and closes at an NAV of $15.05. The market-timer then sells the shares, pocketing the gain.

Let’s walk through this scenario for an ETF investor.

First, the ETF investor can get out any time during the day. It is a great feature and while not needed all the time for most investors, nevertheless useful to have for whenever needed. An important part of this flexibility is not trading directly with the ETF sponsor, but instead trading with market makers. The transparency of an ETF ensures that both investors and market makers can make an informed decision on the value of the ETF shares. The way a market maker gets compensated for providing this liquidity is through the spreads associated with the ETF.

As we saw last week, let’s assume that the US market is down 2% and the ETF investor wants to redeem. The trading price relative to the indicative value of EEM was trading at a discount. The reason why this happens is the same reason as in the mutual fund scenario, except now instead of a unique singular policy of a mutual fund sponsor, all market makers and investors are pricing the international ETF at what they determine is the fair value price. In an ETF, both selling and buying investors can set limit orders to determine value, and the market makers can facilitate the trades, matching those buyers and sellers. With all this activity, what is the impact on the existing holders of the ETF? Nothing.

All of these transactions have occurred on the exchange away from the Fund itself. With this pricing, investors received the best representation – a wide group of market participants valued the underlying securities of the ETF – it is a “crowd sourced” version of fair value pricing. But remember, it is not a free lunch when you have the scenario that appeared to happen last week, which was far more investors selling than buying. This means the market makers are on the other side of the trade so the sellers are trading with the best prices available. The market makers are not only establishing their fair value for the ETF, but also the risk they take on for holding the ETF, which can include both the cost of hedging and the risk bearing that the international markets open up differently (and possible worse) than expected.

As mentioned in the mutual fund scenario above, what if everyone is wrong and the international markets do not open down 2%? Who bears this risk? In the case of an ETF, it is neither the investor who redeemed nor the existing shareholders. The market makers bear the risk (or more specifically the Authorized Participant (AP) who is requesting the redemption in the ETF). Why is that? The redemption is not in cash, which puts the execution risks on the fund and the portfolio manager. Instead, the market maker/AP will receive a basket of securities (of which the size and composition is transparent each day). To be specific, similar to the mutual fund example above, the redemption of $10 million represents 10% of the outstanding shares of an assumed $100 million dollar ETF. Those 10% of redeemed shares will get 10% of the underlying securities in the ETF. When the AP receives the basket of securities, those securities will be whatever they are worth when the international markets open.

We hope this explanation makes sense, and don’t mean to characterize there is not a cost for that liquidity. We only look to point out a few items. Both mutual funds and ETFs use fair value pricing to help protect departing and existing shareholders. With the mutual fund approach, there is a very non-transparent pricing process that will likely negatively impact long-term shareholders or selling shareholders and give investors no control over execution pricing. With an ETF, there is a very transparent process that put the expenses on investors who are using the liquidity feature, but still allows them to control their execution price. If selling investors believe the market is too oversold (the ETF is selling at an incorrectly valued price), they can place their limit orders and get out at the price that they believe represents a reasonable value. If investors believe there are lower prices to come, they can get out immediately.