ETF Capital Markets Desk: Fair Is Fair

If you’ve tuned into the major financial news channels in the wee hours of the morning, you may have heard the term “fair value” kicked around before the US markets open—but what does it mean in the realm of exchange-traded funds (ETFs)? David Mann, our head of capital markets, Global ETFs, explains using a fun riddle.

A man walks into a bar and asks, how can an exchange-traded fund (ETF) that is trading at a premium also be trading at a discount?” Read on to get to the answer of this riddle as I discuss the concept of an ETF’s “fair value.”

I have talked a fair amount in previous commentaries about the differences between an ETF’s price and the price of its underlying basket of securities whether as part of an intraday optimized portfolio value (IOPV) or as part of premiums and discounts.

Specifically in the premiums and discounts article, I did a deep dive into their cause and how this is often quite normal for ETFs that hold underlying stocks in certain overseas markets that are closed for trading when US markets are open. The price of the ETF during the US trading session will be driven by what the market expects will happen when those closed markets re-open the next business day. This is otherwise known as price discovery.

That led to the following question from one of my readers: “What exactly is ‘fair value’ for an ETF? Is this another calculated value we need to understand when trading or investing in ETFs?”

So, I am going to take a stab at defining an ETF’s fair value here.

Let’s get the easy stuff out of the way. Fair value tends to be focused on US-listed ETFs that hold international securities where markets may be closed during the US business day. For US-listed ETFs that hold US stocks, the ETF price throughout the day will be in line with its intraday net asset value (NAV), and the premiums/discounts tend to be minimal.

So we are focusing on ETFs that hold stocks listed on markets that are closed during the US trading day. As I have discussed in a previous blog about trading during holiday periods, the ETF’s price will reflect where the market expects those closed markets to be priced the next day upon re-opening.

However, many investors will have different opinions as to what closed markets might do the next trading day. Fair value is simply the term used to describe how each of those investors value those closed markets during US hours.

As always, let’s use an example.

Suppose today is Tuesday and there is a US-listed ETF that exclusively holds Asian securities. The value of its basket, based on those securities where the market is closed, is $100.

At 11:00 a.m. EST, the major US equity indexes are up 1%. So what is the fair value of our ETF?

John Doe investor thinks that whatever happens in the United States will happen in Asia the next day and thus expects all of the Asian stocks to be up 1%. The fair value for his ETF is thus $101.

Jane Doe investor thinks that whatever happens in the United States will have absolutely no bearing on what happens in Asia. If the value of the basket is $100, then the fair value is also $100 for her ETF.

Meanwhile, Jim Doe thinks more like John, but also thinks Asian equities are more volatile than those in the United States. He thinks whatever market move happens in the United States will be magnified by 25% in Asia (positively or negatively). Thus, the fair value for his ETF in this case is $101.25.

Although I am giving examples of fictional investors, the reality is that the firms who determine their fair values have spent years analyzing the information during the US trading session that can drive the price movements of international equities. For the most part, market participants tend to have somewhat similar ‘fair values’ which tend to be an accurate predictor of what those closed markets will do the next day

Back to our example. As it turns out, our ETF is trading at $100.70 and closes at that price. You can now see the possible confusion:

“Your ETF closed at a premium!” – True! The official premium is 70 basis points (bps).

“Your ETF is trading cheap!” John and Jim would agree with this as to them it is trading below their fair value.

“Your ETF is trading rich!” Jane would agree with this, as to her it is trading above fair value.

At the end of the day, the on-exchange ETF price is the only one that is truly actionable throughout the day. With that being said, we can now start seeing how price discovery and the actual price of the basket together can drive the price of US-listed ETFs with underlying stocks that trade in underlying markets which are closed during US trading hours.

Back to my riddle at the beginning of this piece. Yes, it is indeed possible that an ETF could close at a premium yet be trading cheaply, when talking in terms of fair value. Yes I know—it’s all mind-blowing stuff!

In my next article, I will explain further why you should care about fair value and will incorporate ETF arbitrage into this discussion. So, stay tuned!

David Mann’s comments, opinions and analyses expressed herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

This information is intended for US residents only.

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