Exchange-traded funds (ETFs) are generally seen as a low cost way to build a diversified portfolio of assets, but new research published in IIJ has highlighted a big hidden cost that often goes unnoticed by investors. Seemingly small bid-ask spreads for many ETFs can mask much higher transaction costs when market prices deviate from net asset values (NAV). Certain types of orders could result in investors overpaying for these ETFs by a wide margin.
For example, suppose that an ETF is trading at $10 per share. If the individual components of the fund are only worth $9.95 per share, then the ETF is trading at a 0.5% premium to NAV. This can become a problem for the investor if the premium is reduced or moves to a discount during the holding period. In this case, the investor must account for these costs in the total return calculation, and they will reduce the profitability of the ETF position.
In this article, we take a look at how transaction costs can eat into ETF returns and what investors can do to mitigate them.
What Is Net Asset Value?
An exchange-traded fund is simply a portfolio of equities (or other assets) based on the composition of an underlying index, or it can be actively managed. For example, the SPDR S&P 500 ETF (SPY ) holds a portfolio of just over 500 equities underlying the S&P 500 index. Investors purchasing the SPDR S&P 500 ETF are essentially holding a fraction of each equity in the S&P 500 index without having to purchase each equity individually, incur transaction costs and keep them rebalanced over time.
Net asset value refers to the aggregate value of the ETF’s portfolio at a given point in time. In general, the NAV per share could be equal to or close to the market price per share. Any large disparities between the two would lead to arbitrage opportunities. For example, a discount to NAV would mean a large investor could simultaneously buy ETF shares and short sell the S&P 500 to realize an immediate profit equal to the difference between the NAV and market price.
That said the IIJ research has shown that ETF closing prices are more than 90 basis points away from the NAV approximately 10% of the time. This drag occurs for a number of reasons, including covering the creation and redemption of fund shares, hedging position risks and funding other operational costs for market makers. Of course, this cost due to the drag isn’t reflected in the bid/ask spread and may go under the radar of most investors.
Order Execution Details
Market-on-close orders (MOC) are non-limit orders that are executed as close to the end of the market day as possible. According to the IIJ research, investors’ MOC orders are likely to be executed at prices below the NAV, which suggests it may be an effective way of avoiding these costs. ETFs must trade at their NAV by the close of the trading session, which means that orders executed close to that time tend to be closer – but it’s still not an absolute guarantee.
A notable exception to the rule is dealing with international ETFs. In these cases, the true NAV of the ETF – driven by foreign securities – may vary when the U.S. market is closed. Investors in these cases risk paying a premium to the NAV when trading during U.S. hours. Unfortunately, there are no ways of mitigating these risks effectively other than ensuring that the component equities are relatively non-volatile and the ETF itself is highly liquid.
Investors can find details surrounding the premiums and discounts for ETFs by looking at the issuers’ websites or using brokerage platforms.
The Bottom Line
Exchange-traded funds have become enormously popular over the past several years as an easy and affordable way to build a diversified portfolio of different asset classes. While bid/ask spreads may seem relatively tight in most cases, most investors forget to look at the premium to net asset value as another cost of buying and selling ETFs. The best way to avoid these costs may be to purchase ETFs towards the end of the trading day, although doing so is still no guarantee.