Stock prices keep moving, even after the exchanges close
• Most ETF iNAVs are based on closing prices in local markets.
• A mechanism that captures the fair value of a security after its local exchange closes allows ETF investors to react quickly to unforeseen events.
• Real-time fair value pricing of an ETF’s underlying securities helps investors make well-informed investment decisions.
One of the keys to success in the financial markets is having enough information to make informed investment decisions. Nowhere is the old maxim that “knowledge is power” more true than when it comes to investing, particularly when it comes to exchange traded funds (ETFs).
Things were simpler when markets were more segregated and U.S. investors only traded in securities sold on U.S. exchanges. As finance has become a truly global business there are always markets that are trading while other markets are closed.
When investors buy equity shares outright, the price is simply whatever was quoted on the respective exchange where that stock is traded at the time of purchase. For ETFs traded on U.S. exchanges but composed of a basket of foreign equities, things can get more complicated.
An ETF provides an end of day net asset value, which is generally calculated using close of market prices for the underlying securities. In addition, the Securities and Exchange Commission (SEC) requires every ETF to publish a daily indicative net asset value (iNAV) of the portfolio which that ETF tracks. The indicative, or intraday, NAV differs from a NAV calculated at the end of the day, as on a mutual fund, in that it represents an indicative “real time” value. For example, the iNAV of an ETF that tracks the S&P 500 would represent the most recent price of every security in the S&P 500. That valuation helps investors gauge whether the price of the ETF that’s tracking all those securities is “fair” or at least within the ballpark.
Why advisors, and their clients, should care about fair value
With international securities listed on overseas exchanges, whenever that market closes locally, the iNAV closes. For European equities, that occurs while there are about four and a half hours before trading closes in the U.S. The situation with securities traded on Asian exchanges is even more disconnected, since those exchanges are likely to be closed while the ones in the U.S. are open, meaning that in many cases the information is up to 12 hours old before a U.S. ETF investor is able to act on it. Currently, the simplistic approach to iNAV does not always provide investors with a fair indication of the price at which they would be able to buy or sell the ETF.
On many days the difference amounts to no more than a few basis points, but there are days when unforeseen events trigger a difference in value of several percentage points. These events might affect an entire country or region, such as a natural disaster, terrorist act or political upheaval or they might be unique to an individual company such as a negative earnings report or change in management. Intervening events might also include price movements in U.S. markets that are deemed to affect the value of foreign securities. Having a mechanism to capture the fair value of a security after its local market or exchange closes can help investors understand the price movement in their ETF during these times.
A much better approach than the previous closing price is to use a mechanism that continues to determine the fair price of the underlying securities in between the close of the local exchange and the U.S. market. Interactive Data Corporation’s ETF Services has developed a model that includes fair value-adjusted inputs for international equities as part of the published iNAV. IDC uses a model that incorporates news and trading information into determining the fair value, which can be an extremely useful tool for anyone trading international equity ETFs.
IDC utilizes a patented, bottom-up methodology to determine and incorporate the relationships between price changes in local markets and various factors available during U.S. market hours. It analyzes fair value information for each covered equity security using a four-step process, and refigures the fair value every 15 seconds, according to strict quality controls. This way an investor considering an ETF tied to a market that has been closed for hours has a price point to reference before making a decision to buy or sell.
To show how the process can work, consider an ETF composed of a basket of European securities. In determining the fair value of that portfolio, IDC would look at each of the securities in that basket and at the historical relationship each had over the previous 12 months to active instruments, such as the S&P 500 or international futures contracts that trade until the U.S. market close at 4 pm. If there’s a particular security that moves 1.5% for every 1% the S&P 500 moves, the algorithm would make an adjustment of that amount to that individual security.
At a time when financial consumers have become increasingly skeptical of many Wall Street firms, the transparency provided by an independent data provider can prove invaluable to a fund. It can give the same type of discovery that many people get from doing price comparisons on their smart phones while out shopping in a retail outlet.
Any trading strategy is only as good as the underlying data that investors have at their fingertips, and real-time fair value pricing can help investors make well-informed investment decisions. It is not perfect, but it does represent an improvement over what has been previously available. And that’s probably a good thing for the ETF industry as a whole.
Matt Collins is Executive Director of Investment Management at Source. Source is a global investment firm and dedicated Exchange Traded Fund (ETF) provider. Matt Collins is a registered representative of Fund Source (US), LLC.
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