Investment Company Notebook

Practical insight and analysis on the accounting, audit and tax issues impacting investment companies.

Should an ETF Investing in Foreign Securities Utilize Fair Value Adjustment Factors?

Should an ETF investing in foreign securities utilize fair value adjustment factors? Before answering this question, we should address why investment companies use fair value adjustment factors. Funds that invest in international securities could be subject to market timers looking to take advantage of the arbitrage that may occur between the time a foreign stock exchange closes and the time the U.S. stock exchange closes. The market timer buys into the fund and then sells out of the fund the next day, driving up costs and diluting the share value for long-term investors.

In order to combat this market timing, the fund can utilize a fair value pricing service that supplies an adjustment factor that will account for events that have occurred after the foreign stock exchange has closed, and thus shrink the opportunity for arbitrage to occur.Untitled design - 2021-06-28T115130.465

Using a fair value factor makes sense for an open-end mutual fund where shareholders buy in to the fund and redeem out using cash, but does it make sense for an ETF? Only authorized participants are allowed to subscribe or redeem creation units directly from the ETF at NAV. For all others who wish to make purchases of the ETF, they can only do so on the secondary market, where shares trade at market price. In the secondary market, the shares may trade at a premium or a discount. While it may be possible that those trading on the secondary market may try to take advantage of arbitrage opportunities that occur between the closing of the foreign stock exchange and the U.S. stock exchange, their trading activity should not affect the NAV of the ETF.

As an ETF investment strategy typically tracks an index, authorized participants (“APs”) typically subscribe to an ETF through a subscription-in-kind (and redeem out through a redemption-in-kind) of a basket of securities that mimics the underlying index whose return the ETF is trying to achieve. This helps to lower the transaction costs for the ETF. Following this scenario, the opportunity for arbitrage is decreased as the AP buys in with a basket of securities, and then redeems out with the same basket of securities. However, APs also may create and redeem shares with cash-in-lieu of certain securities or purchase or redeem creation units entirely in cash. One might think that with cash-in-lieu or all cash transactions, APs might still have an opportunity to market time the ETF. However, in most cases the AP is charged a variable fee on cash transactions to cover certain brokerage, tax, foreign exchange, execution, market impact and other costs and expenses related to the execution of the trades. This variable charge effectively mitigates any opportunity for an AP to market time an ETF. Therefore, it is generally considered unnecessary for an ETF to apply fair value pricing factors to combat market timing.

Another consideration in using fair value pricing factors is financial reporting. Under GAAP, all investment companies are required to state their investments at fair value. Foreign stock market post-closing events, if not accounted for when the investment company strikes its NAV, could lead to a financial statement misstatement. The ETF should evaluate the impact of stock market post-close events and consider the need to adjust the values for financial reporting dates.

In conclusion, it is generally unnecessary for ETFs to apply fair value pricing factors to combat market timing. However, to be in compliance with GAAP for financial reporting purposes, fair value pricing factors should be considered. The artificial tracking error between the ETF’s total return and the underlying index’s total return can be eliminated by the use of a service provider that adjusts the underlying index to account for significant events after the close of the foreign stock exchange.

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