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Thursday, March 4, 2010

Mr. Hougan Needs to Read His Own Sister Publication

As I noted before the "Hougan" theory about bond etfs is detached from the reality of the markets. The new issue of his sister publication entitled Etf Liquidity Explained highlights the point albeit subtly and someone not knowledgeable about how markets work might miss it.

My bolds my comments in blue

One of the most important factors in determining what is a fair price at which to trade an ETF is the extent to which the ETF deviates from its NAV. While the arbitrage described above suggests that this should theoretically never happen, in the real world—and for a variety of reasons—it does.
so here is the deviation from NAV that Hougan is so concerned with. But note its implications:

Asymmetry And Arbitrage Channels In ETF TradingAsymmetry in the arbitrage process typically occurs when the bid-offer spread for the underlying constituents is wider than the bid offer spread for the ETF itself. When this condition exists, the ETF often fluctuates between prices that are bound by the arbitrage bands: APs are unable to directly arbitrage the ETF within this band, since the cost of assembling the underlying basket of securities is higher than the bid/ask spread of the ETF itself. Understanding when and where this can happen is important for those trading ETFs, because when there is asymmetry in the arbitrage market for a given ETF, large buy orders will have a different level of impact on the ETF market than large sell orders.
For example, in December 2009, IWM had an average bid/ask spread of $0.010 per share. During the same period, the underlying basket of securities in IWM had a combined average bid/ask spread of $0.122 per share. This twelvefold difference creates a vast amount of space for IWM to trade within before arbitrage becomes profitable.

In other words if Mr, Hougan would look carefully at the Bloomberg screen he writes about it : if one were to execute market orders for the underlying securities and market orders for the etf, the etf buyer would wind up better off. In fact if the etf was bought at the offer and the stocks sold there would be a theoretical arbitrage for the etf buyer. Add in the commissions and the higher likelihood for slippage and difficulty of execution for the underlying stocks and you get an idea of the advantages of the etf

This would be even more the case for corporate bonds or high yields. The bid offer for the underlying bonds would vary among dealers and be very difficult to execute. Calculating an NAV that represents the actual prices the securities in the index could be bought or sold yet the HYG high yield etf and the lqd corporate bond etf often trade with bid ask spreads of $.01.

The article continues

Investors should be able to drive most trades in ETFs within the channel suggested by the NAV bid/ask spread. But within that channel, large buy and sell orders can and will drive the price of the ETF toward the top or the bottom of the channel.

In other words comparing prices to the NAV with corporate bonds is silly. The etf represents the market as it is trading, the market makers adjust the etf price to reflect what is going on in the market not the last reported price for all the bonds in the index no matter when they last traded as the intrinsic value on Mr. Hougan's bloomberg machine does. The bloomberg terminal is pretty usesless if you don't know how to interpret the data.

Bottom line: rather than shying away from bond etfs they are a far more better alternative than buying illiquid individual bonds with no consistent pricing. And as for the active bond mutual fund, no one really knows how much the bond prices used in calculating their NAV actually represent the price at which their bond holdings could be sold. Unlike the trading price in the etf which represents where real money is on the line for the market makers, the bond fund's NAV need have no connection with market reality. And there is not consistency among funds as to how it is calculated.

Considering  the choice between individual bonds, actively managed bond funds and etfs....advantage etf/

1 comment:

supertrooper2002 said...

The situation is a bit more nuanced. Each ETF is hedged differently and this is reflected in bid-ask spreads. For IWM, the cash basket is not the primary hedge. Usually the Russell 2k future is used or sometimes it is spread off in another large, liquid future. This is generally the case when you see tight spreads. However, once you have an ETF that is hedged using cash baskets or an illiquid future, there is a matching increase in bid-ask spread (as is seen in many international ETFs). The main point of this discussion however is to understand what you own. Each product has different methods of construction and thus different ways that they can deviate from their intended purpose/index. Not all products with the same name or index are created equally or even similarly. These issues matter very much.