ETFs Need Their Own Accounting Rules- Part I

Posted by Investment Management Group on Apr 15, 2010 11:10:17 AM

As I am starting to work with more and more Exchange Traded Funds (ETFs), it is becoming increasingly apparent that they need their own specific set of accounting and reporting rules. Currently, an ETF falls under the guise of an open-end management investment company registered under the Investment Company Act of 1940. While this classification is technically correct, there are certain rules / guidance for open-end 40 Act investment companies that really do not make sense for an ETF. One example is the method by which Total Return is required to be calculated. Another, while admittedly more debatable, is the use of fair value adjustment factors when valuing investments domiciled on foreign exchanges for the purposes of determining the daily net asset value (NAV) of the ETF.

First, it may be worthwhile to explain, in very general terms, the difference between an open-end mutual fund, a closed-end mutual fund, and an ETF. An open-end mutual fund is an investment company that sells and repurchases shares at its net asset value directly to and from the investor. There is no secondary market for an open-end fund as the fund acts as the buyer or seller in each transaction. On the other hand, a closed-end mutual fund is an investment company whose shares trade much like the shares of a common stock. The fund may issue shares at net asset value via a public offering and repurchase shares via a stock re-purchase plan. However, shares of closed-end funds are primarily purchased and sold in the secondary market at the market price, which may be more or less (premium or discount) than the fund’s net asset value. An ETF is kind of a hybrid of an open- and closed-end fund. An ETF can issue and redeem shares at net asset value to qualified participants in exchange for a basket of securities that correspond with the index that the ETF is designed to track. This issuance of shares is commonly referred to as creation units, which are normally issued in lots of 50,000 shares. The qualified participant can then trade these shares in the secondary market. Most investors do not qualify to obtain or redeem shares directly from an ETF and thus must purchase and sell the ETF shares in the secondary market at market price, which again may be more or less (premium / discount) than the net asset value of the fund. If the shares of an ETF begin to trade at a significant discount, a qualified participant is able to purchase a block of shares in the secondary market at the discount and then redeem them at net asset value from the fund and benefit from the arbitrage in price. If the shares are trading at a significant premium, qualified participants have incentive to create more shares and sell them in the secondary market at a premium, again profiting from the arbitrage in price. This ability of qualified participants to profit from arbitrage in price effectively keeps the discount/premium of most ETFs in a reasonable range. So, as you can see, an ETF has characteristics of both a closed-end and open-end mutual fund.

The SEC, in the instructions to Form N-1A, provides the mechanics on how to calculate Total Return for an open-end investment company. The instructions require the assumption that an investment is made at the NAV at the beginning of the period and redeemed at the NAV at the end of the period, with any distributions reinvested at the NAV on the ex-dividend date. As an ETF files its registration statement on Form N-1A, Total Return is required to be computed based on this NAV formula. This provides a Total Return that no investor could ever achieve. Yes, qualified participants could purchase and redeem shares at NAV, but reinvestment of distributions is generally only available at the discretion of the broker and, if permitted by the broker, the shares are purchased in the open market at market price. However, most investors would need to purchase and sell their shares and reinvest their distributions at market value.

Closed-end funds provide a Total Return assuming market value at the beginning and end of the period with reinvestments of distributions made at the lower of the cost or market value. Many ETFs also present a Total Return using this methodology in their financial highlights. This calculation for an ETF would provide a return that comes close, and in some cases (if the market price on ex-date was lower than NAV) accurately reflects the return earned by investors who are not qualified participants.

It would make most sense to require ETFs to provide two Total Returns. The first would assume the investment was made and redeemed at the NAV with any distributions reinvested at the market price. This would accurately reflect the return earned by the qualified participants. The second Total Return should be calculated assuming an investment was made, redeemed, and any distributions reinvested at market price. This Total Return would accurately reflect the return earned by individual investors.

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