One of the more exciting innovations in the financial markets has been the Exchange Traded Fund. By acting as a publically traded fund without redemption, ETFs have given investors access to extremely cost effective diversification, indexing, and even analytical expertise. This allows even the smallest of investors to diversify their portfolios, and maintain access to all aspects of the capital markets.
However, it is important to remember that these instruments are actually just derivatives, and can carry all the risks associated with an asset that does not determine its own value. Throughout the course of this article, I’m going to discuss what kind of risks an ETF carries due to its nature as a derivative. In the next article, I’ll then follow up with some strategies for taking advantage of these inefficiencies to better secure and monitor your personal portfolio.
The first thing to think about when valuing an ETF is its presence as a fund. More specifically, we want to look at the Net Asset Value of its holdings, and figure out whether it is trading at a discount, premium, or at par. This is important, because it shows us the value opportunity presented by the fund. If we can simply buy the ETF at a discount to NAV, we are essentially getting all the positions inside the fund for a discount.
Remember that there will still be a management expense involved in the fund, you’ll also want to factor that into your equation as a natural ‘premium’. If the discount to NAV remains, even after you’ve added back in the fees, you’ve got a pretty good value opportunity. From there, we want to evaluate the quality of this discount by seeing how that pricing discrepancy reacts to changes in the prices.
The R-squared metric is a good way of determining this, because it shows us the correlation between the price of the fund and its underlying assets. If it appears as though the correlation is high, this means that the ETF presents a good representation of the assets its holding, and would be a suitable investment. If not, we would be dealing with a more speculative investment, because we’d be investing more in the returns of the ETF itself than the returns of the underlying securities.
Another thing to remember about ETF trading is that the securities are not being redeemed by the company itself, but are publically traded. This means that the price of the security, unlike a mutual fund, will not be guaranteed, and therefore needs to be supported by purchasing volume. Just like trading a stock, if there is low volume, there will be a high bid-ask spread, meaning that we will immediately take a loss if we try to resell the asset right away.
Always remember keep in mind bid-ask risk when making a purchase, and ask yourself if you will be able to make returns above and beyond the barrier that such a spread presents. Given that volume will also represent the ability of the ETF to maintain its correlation to the underlying securities, we can also use it as an indicator of whether or not we want to maintain our position in times of uncertainty. If volume begins spiking, the ETF might begin to more closely reflect NAV, thus closing the bid-ask spread, and presenting a selling opportunity. If the volume is low, we might see a bit of a buying opportunity for the same reason.
Now that we have a better understanding of how it is that these securities trade, let me show you a strategy that helps to secure the yield of an ETF, while protecting against the capital fluctuations in the price caused by inefficiency.
