How ETF Issuers Can Mitigate Market Volatility with Timely Fair Value Adjustments

The Crucial Role of NAV and Fair Value Adjustments

NAV calculates the per-share price of an ETF's assets minus liabilities, divided by the number of shares outstanding. It is crucial for accurately pricing ETF shares daily. However, situations like the Chinese New Year, when Asian markets close for a week, challenge NAV accuracy if significant market events occur simultaneously, such as the outbreak of Covid-19. This period saw heightened volatility and market drops, which were not immediately reflected in the NAVs of ETFs with significant Chinese market exposure due to the holiday closure.

Real-Life Impact of Market Closures

During the Covid-19 outbreak at the beginning of the Chinese New Year in 2020, ETFs holding Chinese stocks faced potential misalignments in NAV. For instance, if the Chinese market had been open, the growing global concern might have caused stock prices to plummet. However, with the market closed, the NAVs remained static, not reflecting the underlying economic impact of the pandemic, leading to potential exploitation by informed traders or substantial losses upon market reopening.

Similarly, if a single stock that significantly influences an ETF's performance is halted due to regulatory concerns or other impactful news, it can create a discrepancy between the ETF’s NAV and the fair market value of its portfolio. Without timely fair value adjustments, this could lead to incorrect ETF pricing, affecting all transactions during the halt period.

Regulatory Insights and Redemption Fees

The SEC mandates a maximum of 2% redemption fees to curb abusive trading practices, pivotal during such volatile periods. For instance, if an ETF's underlying market falls by 10% during a closure, but the NAV was only adjusted for a 2% drop due to regulatory limits, the ETF would bear the additional 8% loss. It's important to note that these losses are ultimately borne by the ETF holders, impacting their investment returns. This example underscores the importance of adjusting the NAV to reflect fair value predictions during extended closures or unexpected events

The Case of Chinese ETFs During the Covid-19 Outbreak

The spread of Covid-19 during the Chinese New Year exposed significant vulnerabilities in the handling of ETF NAVs, particularly those with major holdings in Chinese equities. A wide array of ETFs, ranging from illiquid to highly traded funds like the Xtrackers Harvest CSI 300 China A ETF (

) and the iShares China Large-Cap ETF (

FXI

), serve as critical exposure tools to Chinese markets. When these ETFs experienced sharp declines of around 10% in high volume trading, it was a clear market signal that the Chinese markets were likely to open lower post-holiday. This should have served as an alarm for all ETF issuers to adjust their NAVs appropriately. Issuers without robust procedures for such adjustments risked placing their investors in precarious positions, where holdings could be disadvantaged by market movements restricted by the 2% fee cap on redemptions.

The Role of Market Makers and Traders in ETF Pricing Dynamics

Market makers and traders are central to the pricing mechanisms of ETFs, especially during periods of market volatility or when discrepancies in NAV arise. These professionals often employ a strategy of grouping ETFs that have similar exposures—whether by country, currency, or industry. This grouping allows them to utilize highly liquid ETFs, futures, and American Depository Receipts (ADRs) for price discovery. Subsequently, they adjust the trading values of less liquid, lagging ETFs to align more closely with where the fair market values should theoretically be. This form of arbitrage takes advantage of the time delays and inefficiencies between when an ETF's NAV is calculated and when actual trades on the ETF occur.

Market makers scrutinize the methods by which ETFs calculate their NAVs, seeking opportunities to capitalize on any inefficiencies. For example, if an ETF’s NAV does not adequately reflect timely fair value adjustments during a market disruption, market makers may execute trades that profit from the difference between the outdated NAV and the real-time market valuation they estimate based on comparable, more liquid instruments.

This dynamic places a significant onus on the capital markets teams of ETF issuers. It is critical for these teams to maintain acute awareness of how external events might impact their ETFs and to ensure that their NAV calculations are as accurate and timely as possible. They must work diligently to minimize pricing inefficiencies that could be exploited through arbitrage. Effective communication with lead market makers (LMMs) and authorized participants (APs) also becomes crucial to ensure that the ETF trades reflect the best available information and fair market values, thereby safeguarding investor interests and maintaining market integrity.

Reflecting on Market Vector EGPT and Russian ETFs

Reflecting on last week's discussion of the delisted VanEck Egypt Index ETF (EGPT) and Russian ETFs like RSX and ERUS, there are vital lessons to be drawn in relation to fair value adjustments. In the case of EGPT, the absence of immediate market data during the Egyptian market's closure led to a natural premium due to supply constraints within the ETF. There wasn't overt pressure on fair value adjustments because the lack of trading data didn't immediately suggest a divergence from the NAV reported prior to the closure.

Conversely, the situation with Russian ETFs managed by iShares and VanEck during the geopolitical upheaval surrounding Ukraine was markedly different. These funds faced a scenario where the underlying Russian stocks could not be legally traded due to international sanctions, presenting a clear and immediate need for NAV adjustments.

The swift decision by these issuers to adjust the fair values of their ETFs was crucial. Without these adjustments, any attempts to redeem shares at pre-crisis NAV levels could have led to substantial financial discrepancies, potentially jeopardizing the funds' stability and integrity. By proactively adjusting the fair values, the fund managers protected the ETFs from potential bankruptcies caused by redeeming at inaccurately high NAVs.

Conclusion

The experiences during the Covid-19 pandemic and specific stock halts provide valuable lessons in ETF management. These events illustrate the critical need for dynamic NAV adjustments to accurately reflect market conditions, ensuring fairness and stability in ETF trading. For issuers and market participants, these are not just cautionary tales but vital strategies for future resilience.

About the Author

Nicholas Phillips | President of ETF Capital Markets Advisors LLC
With over 25 years of experience in ETF market making and capital markets, Nicholas Phillips is recognized as a subject matter expert in the ETF industry. He started his career spending the first ten years as a lead market maker for SIG and Goldman Sachs. At the helm of MCAP LLC's ETF Desk, Nicholas built and scaled the division, enhancing its operations through innovative pricing and risk models, and robust relationships with market makers and issuers. His tenure at Van Eck Associates as Director of ETF Capital Markets further solidified his expertise, managing critical facets of operations and deepening connections within the trading community. Beyond market making, Nicholas is an avid content creator, sharing insights that demystify complex market dynamics. He is keen on exploring board member roles that benefit from his extensive background and forward-thinking approach to ETF strategies. His dual US/Ireland citizenship complements his global perspective, enriching his professional endeavors in diverse markets.

Disclaimer

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.