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What To Take Away From A Strange Monday In ETF Land

A number of equity ETFs declined 20% or more Monday morning only to have recovered most of those losses before the close. Since ETFs are a basket of securities, the sharp selloff in many stocks was likely part of the reason. However the ETF structure also contributed to the weakness.

Unlike mutual fund sales or purchases that are executed at the end of the market close, ETFs trade intraday. As such, the prices investors pay can be different than the net asset value (NAV) of the underlying securities. When there is meaningful volume to sell (or buy) an ETF, the ETF will trade a discount (or premium) to NAV. Usually a market maker, known as an authorized participant, will see this arbitrage opportunity and take the other side of the trade. Such action will limit the price-to-NAV differential.

But when the volume is much higher than expected, the differential can grow as we saw Monday. For example, iShares S&P 500 (IVV) closed at $198.79 on Friday August 21. The ETF on Monday traded at $155.99 at 9:33 in the morning (down 22%), before closing at $190.52, a 4.2% decline from the prior trading day. IVV closed Wednesday at $195.68 and was trading at just a 0.05% premium to NAV.

So does this volatility mean investors should avoid ETFs and move back into mutual funds that price only once a day?

We believe the relative appeal of ETFs -- including a typically much lower expense ratio, benefits of passive management, and daily disclosure of holdings -- are no different than a week ago. However, we think a much deserved lesson occurred that ETFs can trade irregularly much as stocks can during times of market stress. Investors that favor active management likely will continue to choose mutual funds, which buy and sell stocks with their own trading desks.

In our view, when an ETF trades at a notable discount or premium to NAV, long-term investors would be better suited being patient and waiting until the differential narrows before making a trade. Because in addition to perhaps selling or buying at prices they might regret, they might also incur a wider bid/ask spread than they would under more normal circumstance. When sellers vastly outweigh buyers and the information available about the ETF's holdings becomes less clear, the spread will grow to protect market markets.

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