Market movements help determine when to move in and out of the funds
Taking swift advantage of what the market is offering doesn't necessarily make one a market timer or day trader. It can be an effective way to navigate certain corners of the exchange-traded-fund market.
It turns out that the fear and uncertainty represented by market volatility actually can expose some measurable efficiency gaps across the ETF sector.
In the most basic sense, the direction of market volatility from one day to the next is a pretty good indicator of the short-term direction of an ETF's net asset value relative to its share price.
For investors and financial advisers, this amounts to a relatively simple tool for identifying optimal times to move in or out of certain ETFs.
Although most ETFs are designed to trade very close to the NAV of the underlying investments, there are times when volatility can disrupt the mechanisms that are supposed to prevent ETFs from trading at too much of a discount or premium.
“This could be a way, through sensible trading, to save a few basis points. Or if you're a day trader, you could probably generate about 7% worth of alpha a year just by predicting these things accurately,” said Lee Davidson, an analyst at Morningstar Inc.
He has done extensive research on the correlation between market volatility and ETF NAVs.
Mr. Davidson studied the correlation between volatility and NAV movements of 262 ETFs over the five-year period through December 2011. He found that two-thirds of the time, the direction of an ETF's NAV can be predicted easily.
“I don't look at the levels of volatility, just at the changes in volatility that day, and that will determine how much the premium or discount should change,” Mr. Davidson said.
ETFs essentially have two prices to watch: the share price, or market price, at which it trades, and the NAV, which represents the market value of the ETF's underlying assets.
Whether an ETF is trading at a discount or a premium to its NAV, the research shows a high correlation to volatility during the trading day, which is followed by a day in which the direction of the NAV, predictably, will reverse course.
If market volatility spikes on a given day, any separation between an ETF's share price and NAV often will become exaggerated.
For example, if shares of a particular ETF are trading at $9.90 and its underlying NAV is calculated at $10, then the ETF will be trading at a discount to NAV, which would be considered an attractive value.
But on a day in which volatility spikes, the market price is likely to rise faster than the NAV price, which will narrow the discount.
However, the market forces usually catch up by the next trading day, and the discount tends to come back.
The same goes for ETFs trading at premiums to NAV.
If the share price is $10 and the NAV is $9.90, a volatile day in the markets is likely to increase the premium, which will then be narrowed during the following trading day.
The reason this works in such a predictable manner has to do with the arbitrage mechanism that is designed to keep ETF share prices from straying too far from the NAV.
Ideally, when an ETF's market price is above its NAV, an authorized participant will step in to buy the underlying assets for delivery to the ETF provider, which will create new shares to be transferred to the AP.
BACK INTO ALIGNMENT
The cycle is complete when the AP sells the new ETF shares on the market, which brings the share price and the NAV back into alignment.
Likewise, if an ETF is trading at a significant discount to NAV, the AP will buy ETF shares and exchange them for underlying assets.
However, during times of volatility, arbitrageurs tend to view the time gap between the purchase and exchange as increased risk.
“It makes intuitive sense,” said Brendan Clark, president of Clark Capital Management Group Inc. “If you have a volatility event, the premium or discount will widen because the arbitrage capital is scarce.”
Keeping an eye on market volatility could add some value to select ETF transactions.
“If you make the assumption that eventually, the market price will converge to the NAV price, you will want to buy either close to NAV or the biggest discount you can get,” Mr. Davidson said.
