ETFs Need Their Own Accounting Rules- Part II- The ETF Fair Value Dilemma

Posted by Investment Management Group on Apr 16, 2010 9:48:26 AM

It is imperative for open-end investment companies to value their investments at fair value when determining their net asset value ("NAV"). For investment companies that invest a significant portion of their investments in foreign securities, the importance of fair value is magnified. Due to different time zones, many foreign exchanges close well before the close of the U.S. markets. If significant events occur after the close of the foreign markets, but before the close of the U.S. markets, the closing price of the foreign investments will not be reflective of the current market value. This creates arbitrage opportunities for market timers. Market timers look to profit from these arbitrage opportunities and do so at the expense of the remaining shareholders of the fund. To combat market timers, most mutual funds that invest in foreign securities utilize fair value factors to adjust closing foreign prices to reflect events occurring after the close of the foreign markets but before the close of the U.S. markets. Some funds establish a threshold or trigger of movement that must occur before applying the fair value factors, but more and more funds are beginning to apply fair value factors on a zero threshold basis.

The use of fair value factor is certainly an effective tool for combating market timing in a regular open-end mutual fund, but does it make sense for an exchange traded fund ("ETF")? I think not, though some may consider such an opinion to be controversial. My reasoning is quite simple. Subscriptions and redemptions of ETF shares by qualified participants are made in-kind. If a qualified participant attempts to profit from the inefficiencies in the pricing of the underlying securities of the fund by redeeming shares, the redemption will be paid to the participant in the form of the same inefficiently priced securities. While non-qualified participant market timers will certainly invest in ETF shares and seek to profit through arbitrage opportunities, such arbitrage will not come at the expense of the remaining shareholders in the fund since it will be facilitated in a secondary market. Further, it is not possible for a qualified participant to market time an ETF in such a manner that they would profit at the expense of the remaining shareholders of the ETF since as explained above, their redemption of shares will be made in-kind.

Another argument against using fair value adjustments in an ETF is that such practice would create what is commonly referred to as "tracking error." The investment objective of an ETF is generally to mirror the return of a particular index. The tracking error is the extent to which the return of the ETF does not match the return of the benchmark index. All benchmarks use closing prices without fair value adjustment factors. Therefore, the use of fair value factors in an ETF will cause tracking error and may reflect negatively on the management of the ETF.

The only debatable point with respect to fair value factors relates to the trading in the secondary market. To some extent, the trading activity of an ETF may be related to its discount or premium from its NAV. But what are the investors' expectations with respect to how the NAV of the ETF is determined? If events occur after the close of the foreign market that negatively affect the securities in index, would investors in a corresponding ETF expect such an ETF to trade at a discount to the NAV or would they expect the NAV to be reflective of the subsequent event? I would think they would expect the pricing to match that of the index, but the answer is unclear and is the key to solving the ETF fair value dilemma.

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