Another ETF Accounting Trap

Posted by James Kaiser on May 7, 2018 3:30:12 PM

Today I am writing about an accounting error I have been seeing more and more while performing audits of exchange traded funds (“ETFs”).

While reading this post, I think it is important to keep in mind that nearly all fund accounting agents cut their teeth performing fund accounting for open-end mutual funds.  As the ETF industry has undergone significant growth, these companies have naturally expanded their mutual fund accounting expertise to ETFs.  There are a few subtle accounting differences between open-end mutual funds and ETFs.  One difference is that shares of an open-end mutual fund are always purchased or redeemed at net asset value (“NAV”) whereas shares of an ETF may only be redeemed at NAV by Authorized Participants (“AP” or APs”).  Non-AP investors must purchase or sell ETF shares in the open market at market price, which may be higher or lower than the NAV.  Most investors will not qualify as an AP, so the open market is the only avenue available to them to purchase ETF shares. ETFs


As the number of ETFs continues to increase, we are seeing more and more common mutual fund strategies employed in ETFs.  One such strategy is to have a family of ETFs, where one of the ETFs (for the purpose of this post, I will refer to this as the “Feeder ETF” or “Feeder Fund”) in the family holds shares of one or more of the other ETFs (let’s call these “Master ETF(s)” or “Master Fund(s)”) in the same family.  This strategy in a mutual fund is commonly referred to as an Affiliated Fund of Funds and is fairly simple from an accounting perspective.  The Fund Accountant calculates the NAV for all of the Funds in the family, so one can easily value the Feeder Fund’s investments in the Master Fund(s) by utilizing the NAVs of each Master Fund as the market value price.  In fact, many accounting systems are set up to automatically pull the NAVs of the Master Fund(s) to compute the market values of the Feeder Fund’s investments.  Herein lies the problem with this strategy when applied to an ETF. 

As noted above, most investors, including the Feeder ETF in this example, will not qualify as an Authorized Participant and will therefore be unable to purchase or redeem their shares at NAV.  The purchase and/or exit price for the Feeder ETF’s investments in Master ETFs will therefore be the market price on the day of valuation. 

As noted above, this market price will likely be different than the NAV.  Depending on the size of the positions in Master ETFs as well as the size of the market discounts/premiums to the NAV, valuing investments in Master ETFs at NAV as opposed to market price can result in a significant error.  Unfortunately, I have seen this error on numerous occasions.  I attribute this error to the common practice used in computing NAVs of Affiliated Funds of Funds (mutual funds), which needs to be customized when applying to ETFs.

When presented with this error, some have argued that Accounting Standards Update (ASU) 2009-12 “Investments in Certain Entities That Calculate Net Asset Value Per Share” allows an entity to value investments in Master ETFs at NAV.  One often overlooked requirement to apply ASU 2009-12 is that it is not likely that the entity will sell its investments at a value other than the NAV.  As a Feeder ETF can only sell its positions in Master ETFs in the open market, this requirement is not met and ASU 2009-12 is therefore not applicable.

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