ETF Tracking Error: Fact And Fiction

by on March 29, 2010 | Updated May 19, 2014

As the use of ETFs has become more and more widespread, investors have become increasingly curious about exactly how these products work. In recent months, one of the most frequently analyzed aspects of ETF investing has been the efficiency of the trading markets for certain ETFs. Many investors have become concerned with their ability to execute trades for a certain ETF at or near the net asset value of the underlying assets. As a result, more and more advisors and individual investors are utilizing “liquidity screens” when analyzing potential investments.

Some investors have also become obsessed with concept of premiums and discounts, trading only in ETFs that rarely deviate from their NAV. While the potential to get burned by placing massive market orders in thinly-traded funds is very real, there has been a fair amount of misinformation spread about the importance of high trading volumes and low premiums/discounts. The events of last week serve as a good illustration of one of these misconceptions:

On Friday, the net asset value of the iShares MSCI South Korea Index Fund (EWY) gained 0.83% to close at $49.25 per share. But the fund’s market value declined by 0.61%, finishing the session at $48.74, or about 1.6% below the underlying net asset value. This significant disconnect raises some major red flags about the efficiency of the market in EWY, right?

Not necessarily. The big gap between EWY’s NAV and market price last week was due not to inefficiencies in the market for the fund, but rather the nuances of international ETF investing.

Well after the markets in South Korea had closed for the week, a naval ship sunk near a disputed maritime border with North Korea, setting off a frantic rescue effort to save more than 100 sailors on board. Given the location of the explosion, many began to suspect North Korea of having some involvement. Although the South Korean government had not made an official statement, speculation began to swirl, and concerns about an escalation of tensions between two already uneasy neighbors began to intensify.

An armed conflict between North Korea and South Korea, two nations still technically at war (the Korean War ended only in a truce, not a treaty), would obviously be a major negative development for both economies. As such, with a cloud of uncertainty hanging over the region, EWY headed lower in trading on the NYSE Arca Exchange on Friday. Because South Korean markets had already closed (the blast occurred between 9 p.m. and 10 p.m. local time), the fund’s NAV remained unchanged immediately afterwards.

EWY traded more than 8 million shares on Friday, so a thin market clearly isn’t to blame for the disconnect between market price and underlying value. Rather, investors were essentially speculating on the impact that Friday’s developments would have on South Korean shares when the markets in Seoul opened on Monday. And because these developments occurred between the time local markets closed and the time trading on the NYSE halted for the week, it appeared as if EWY was trading at a big discount to its net asset value.

Common Occurrence

This phenomenon doesn’t only occur when major events unfold during a specific window of time. International ETFs regularly develop “time lags” as a result of the differences in trading hours for the fund and its underlying securities. Trading in EWY doesn’t stop once South Korean markets close, just as VGK and FXI trade throughout the day as well. If the S&P 500 rallies after local markets have closed, these funds will likely finish the day reporting a premium to NAV. If U.S. markets slide in late trading, they’ll likely close at a discount.

Some investors like to look at premium/discount charts when evaluating a potential ETF investment. But when considering international funds, this information isn’t quite as useful. Many funds will appear to frequently trade at a material premium or discount to net asset value even if they actually track the underlying index very closely. Failing to understand this aspect of international ETF investing can have two potentially negative consequences. First, investors may be scared away from certain funds because of a perceived lack of liquidity. Second, blind reliance on premium and discount figures may send false signals to those looking for an arbitrage opportunity.

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UPDATE: As of Monday morning, the cause of the blast remained undetermined. South Korean Defense Minister Kim Tae-young told lawmakers that North Korea may have floated a mine towards the ship. He also noted that the explosion could have been caused by a mine placed during the Korean War. Investor nerves were apparently eased by the fact that there had been no follow-up attacks or accusatory rhetoric, as EWY jumped by nearly 1.6% in early Monday trading.

Disclosure: No positions at time of writing.