How ETFs Act as a Price Discovery Vehicle During Market Holidays

by Keegan Toci, iShares

Sunday marked the beginning of the 2013 Lunar New Year, and like any other New Year celebration, businesses will go dark and capital markets will close in the countries where the holiday is celebrated. Because of this, many international ETFs will be affected because some of their underlying securities may not be available to trade throughout the multi-day holiday (see below).  However, during these extended underlying exchange closures, the US market will remain open and US-domiciled ETFs – even the ones that provide international exposures – will continue to trade.   So how do foreign market closures affect these ETFs?

First, it’s important to understand why this matters.  ETFs can be created and redeemed in large quantities throughout the day by market players called authorized participants (APs).  They do so by delivering a basket of the underlying securities to the ETF provider in exchange for a basket of the ETF shares, or vice versa.  When the underlying securities aren’t available to buy or sell – say, because the market on which they trade is closed – the APs need to make an educated guess about where these securities will be trading once the exchange opens again.

You can see how this situation isn’t limited to holiday closures like the Lunar New Year.  Every day, authorized participants in the US have to make these educated guesses in order to facilitate creations and redemptions in US-domiciled international ETFs, simply because the underlying securities trade on an exchange that closed hours ago due to time zone differences.  For example, the iShares MSCI EAFE ETF (EFA) is comprised of securities that trade on stock exchanges in Asia, Australia and Europe, but EFA itself trades on the US stock market during US market hours (see below).

Now, this may seem like a hassle for the authorized participants, but the truth is there are many ways for them to make educated guesses about where these securities should trade when their exchanges are closed. One popular method is to use the percent change of the US market (for example, via the S&P 500) and assume that other countries will have a similar move, while also incorporating the continuously traded foreign exchange market to account for currency movements.

But the takeaway for ETF investors is that there’s an unintended (but very important) benefit to all this, and that is that these US-domiciled international ETFs can actually continue to price in information about the underlying securities even when foreign markets are closed.  It’s a phenomenon we in the ETF business refer to as “price discovery”, and it’s happening every day.

So let’s go back to our Lunar New Year example to see how this all applies.  We already said that this price discovery process is happening every day due to time zone differences, but what happens when there’s an extended closure like this one?  Because an ETF’s net asset value (NAV) is based on the last closing price of its underlying securities, you would expect the NAV for the ETFs in question to go stale over the course of the market closures.  In other words, while the ETF’s market price will continue to price in new information, the NAV will remain the same.  This can lead to a greater than usual difference between the NAV and the market price of the ETF.

How dramatic do we think this difference will be?  Although we’d expect there to be some deviation between market price and NAV, price discovery may still keep these funds in-line with their fair value.  But as time ticks forward, it becomes more difficult to determine the true value of the underlying holdings.  It is worth noting that the bid/offer spreads on affected funds remained at normal levels during the previous Lunar New Year holiday, as did average daily volume. My team, the iShares Capital Markets Group, expects this year’s holiday to be no different.

The bottom line: Every day, in normal and abnormal markets, ETFs are an investment vehicle of choice for providing investors with price discovery.  Time and time again, investors have looked to ETFs to get access to other markets, even when those markets may be closed.  So Gung Hay Fat Choy. Enjoy the holiday – and remember that the closures of so many markets around the world shouldn’t impact your ability to trade an ETF here in the US.

Shares of the iShares Funds may be sold throughout the day on the exchange through any brokerage account. However, shares may only be redeemed directly from a Fund by Authorized Participants, in very large creation/redemption units. There can be no assurance that an active trading market for shares of an ETF will develop or be maintained.

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