Has the ETF Arbitrage Mechanism Failed? -- Page 2

From Discount to Premium
Smaller, spiky discounts on the major bond ETFs persisted through October and into November as stock markets continued to fall and major banks tried to further reduce their corporate-bond exposure in order to decrease leverage. But as the government began to prop up the bank lending and commercial paper markets and volatility began to ease off, a new trend started: The aggregate-bond indexes started to trade at a premium to their net asset values. Once again, this was less a fault of the ETFs than a result of the liquidity in the market for the underlying securities. At the end of 2008, bond markets were calmer as the large spreads on corporate debt seemed to offer sufficient compensation for the newly higher risk of defaults. However, the major banks and trading desks that provide liquidity to the corporate-bond market were still trying to reduce their exposure to risky assets, which entailed lower bond inventories, wider bid-ask spreads, and less trading.

In this environment, institutions and investors willing to take on some of the generously priced risk in corporate bonds would have a hard time assembling a portfolio of actual bonds in a short period, but they could buy a large and fairly diversified portfolio quickly using the liquid fixed-income ETFs. Not only that, but the continued trading of the ETFs through the worst of October and November showed that investors could always get out of their bond indexes if they needed to, even if it would be at severely impaired prices. This flexibility doesn't come for free, and anyone looking for the relative security of bonds coupled with a liquid market has had to pay up, as seen in the premium prices on bond ETFs and Treasury bills from December 2008 into February of this year. Once again, the APs have ignored price differences between NAV and market value that they would formerly have swiftly arbitraged. Although newly created ETF shares would be fairly easy to sell at a premium, these major trading desks would take a while to accumulate the large bond portfolio necessary to create those shares in the thinly traded bond market. During that time, they would have to carry a larger inventory of corporate bonds and the corresponding risk of another sudden market collapse. With the higher risks persisting today and the longer holding periods necessary to build up and sell off the bond stake, APs demand a larger premium before they will perform the arbitrage. Throughout the early part of this year,  iShares Barclays Aggregate Bond (AGG),  Vanguard Total Bond Market ETF (BND), and  SPDR Barclays Capital Aggregate Bond (LAG) all sold for a premium of 1%-3% over their quoted net asset values.

Liquidity Premium
Once again, the NAV may have been a less accurate estimate of these ETFs' fair value than their market price. Liquidity, the ability to sell out of an asset when everything goes haywire, is a major risk factor even though it is invisible during normal markets. The shares of these ETFs and their underlying bond holdings may seem equivalent, but the ability to sell off the ETF shares in any market makes them intrinsically less risky and thus commands a premium price when investors fear a sudden return to volatility. As bond markets return to normal, the liquidity premium will shrink and ETF investors who bought the fund at elevated prices will find their returns lagging the underlying bonds (and similarly, the net asset value returns). But that is the cost of avoiding being stuck holding the assets in case of total collapse.

Ultimately, the quoted net asset value is only as accurate as the asset prices that feed into it. As markets freeze up or remain illiquid, stale prices can cause an index or quoted net asset value to stray from the market's sense of its "true" value. For hard-to-replicate indexes and ETFs in illiquid markets, this can even lead to the index futures or ETFs trading at a persistent premium as investors pile into the more liquid single security and are willing to pay a slight premium over the market value of the underlying assets for the ability to buy and sell their exposure more easily.

These deviations from NAV do not necessarily suggest that the arbitrage mechanism on ETFs has failed, nor that investors are buying ETFs at unfairly high or low prices. Many of the largest ETFs are among the most liquid market-traded securities out there today, with the most frequent trading and deepest order books. Individuals, pension funds, and Wall Street trading desks alike move masses of money in and out of these funds, setting prices by the minute even when the underlying securities remain in deep freeze. In times of unusually high market risk, the mismatch between market prices and NAVs for some ETFs is not just foreseeable, but it is also probably some of the best evidence we have that these funds are working to provide market participants with more liquidity than ever before available.

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