ETF Tracking Errors in Rout Shows Access Comes With Risks

Investors lured to exotic assets by the convenient access that exchange-traded funds provide were reminded last week that they can’t dodge the volatility or illiquidity of those markets.

Dozens of ETFs, mainly those tracking emerging-market stocks, sold at big discounts to their underlying holdings as investors fled developing nations. The $468 million iShares MSCI Indonesia Investable Market Index Fund, run by New York-based BlackRock Inc., traded 7 percent below the value of its holdings on June 20, the largest discount among U.S.-traded ETFs with at least $100 million in assets, according to data compiled by Bloomberg.

There was nothing wrong with the ETFs. Rather, the discounts -- during U.S. trading hours while exchanges hosting many emerging-market stocks were closed -- reflected expectations among market makers for continued price declines. The MSCI Emerging Markets Index dropped 5.6 percent last week, the worst slump in 13 months, after U.S. Federal Reserve Chairman Ben S. Bernanke said June 19 that the central bank’s bond buying may be trimmed this year.

“ETFs are going to forecast expected moves overnight for those markets,” said Reginald Browne, head of Knight Capital Group Inc.’s ETF trading desk in Jersey City, New Jersey.

ETFs trade like stocks on an exchange and hold baskets of securities, typically replicating an index. They offer an easy way to buy and sell a diversified selection of stocks, bonds or other assets, often providing access to markets that are difficult for smaller investors to use.

‘Questionable Liquidity’

Investors shouldn’t think an ETF’s listing on a U.S. stock market will shield them from turmoil or lack of liquidity in a fund’s underlying market, David Nadig, director of research at San Francisco-based research firm IndexUniverse LLC, said in an interview. Lack of liquidity, either because an overseas exchange is closed or a result of certain securities trading infrequently, can put stress on the pricing of ETFs relative to asset values, leading to an expanded tracking error.

“In times of market turmoil, you see stress on the creation-redemption process,” Nadig said, referring to the way the funds issue or redeem shares. “As soon as you see uncertainty, you’ll start to see things spread out in ETFs that have questionable liquidity to start with.”

Amid heavy selling by investors on June 20, Citigroup Inc. stopped acting as an agent for clients wanting to redeem large bundles of shares directly with ETFs.

Citigroup’s Limits

Citigroup has limits “on the amount of ETF redemption business we can do on a nightly basis,” Danielle Romero-Apsilos, a spokeswoman for the New York-based bank, said in an e-mailed statement. “Given recent increases in volume, we hit those limits.”

“At no point did Citi discontinue its market-making activities in ETF products,” Scott Helfman, a spokesman, said in a separate e-mail, referring to the role of quoting prices to buyers and sellers of ETF shares to facilitate transactions.

Other firms, including Knight, continued taking redemption orders. “It was a very robust day,” Browne said.

Discounts in several emerging-market funds decreased by the end of the week as some indexes rebounded or stabilized. The iShares Indonesia ETF closed the week with a premium of 1.2 percent after its shares rose 3 percent.

Large discounts also struck ETFs tracking the U.S. municipal-bond market, where Bernanke’s comments spurred selling as well.

Municipal Bonds

The $3.5 billion iShares S&P National AMT-Free Municipal Bond Fund, known by its ticker symbol MUB, reached its deepest discount in more than two years. Its price dropped to $102.29 last week, the lowest since May 2011, and the fund’s 2.9 percent discount was the steepest since December 2010.

“The move down in price has been so fast that the net asset values haven’t yet been able to catch up with it,” Matt Fabian, a managing director at Concord, Massachusetts-based Municipal Market Advisors, said in a telephone interview.

As yields on municipal debt increase, MUB has been selling at a discount to its underlying assets for 18 trading sessions, the longest stretch in more than two years, according to data compiled by Bloomberg.

The $216 million SPDR Nuveen S&P High Yield Municipal Bond Fund saw its discount reach 4.8 percent on June 20, a 52-week high. The gap ballooned after State Street Corp., the fund’s sponsor, stopped allowing market makers to redeem shares for cash.

State Street

ETFs are obliged to redeem large bundles of shares for baskets of their underlying securities, leaving the withdrawing investor, or its agent, to sell the securities for cash. State Street often offers the redemption in cash for an extra fee, Tim Coyne, the Boston-based firm’s global head of ETF capital markets, said in an interview.

State Street stopped giving market agents that flexibility because deteriorating conditions in the municipal-bond market made trading more costly than the fee the fund could charge for the service, he said.

“We did not stop redemptions,” Coyne said. “The funds actually performed very well and exactly as designed.”

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