The Institutional ETF Toolbox. Balchunas Eric

are closed. Suppose news in the United States of new Russian sanctions comes out at 2 P.M. EST. Russian ETFs will trade immediately on that news and inform investors as to what the underlying Russian stocks are worth and where they may open. This also applies to less liquid areas of fixed income as well.

      “ETFs in many ways offer opportunities in price discovery in fixed income. Very much the same way when you trade Japan or Germany equity ETFs. When those markets close, that doesn’t mean there isn’t a value or people stop thinking about the situation.”

Linda Zhang, Windhaven Investment Management

      Day-to-day, ETFs are slowly starting to replace indexes as the proxies for different markets as well. And why not? Unlike an index, you can actually invest in the ETF.

      Beyond the day-to-day, there have been some extreme examples where the ETF served as a discovery tool in market-moving events when markets were closed or incredibly stressed.

      One example is after the terrorist attacks of 9/11 and SPY. All trading of stock and bonds was halted from 9/11 through 9/17. When trading opened at 9:30 A.M. on 9/17, SPY began trading immediately and effectively, even though some of the stocks in the S&P 500 had not yet begun trading. Because of this, investors were able to use SPY as a price discovery vehicle and make implied valuations on those stocks that not yet begun trading.

Another example is when Egypt’s stock market closed for two months between January and March 2011 due to violent protests in the country. The Market Vectors Egypt ETF (EGPT) continued to trade and serve as a guide as to where the market was trading. Many used the ETF to trade Egypt as volume on the ETF more than tripled during the time – all the while, investors holding individual Egyptian stocks were locked up entirely. They had no venue to unload or acquire those shares. Not surprisingly, the ETF deviated from the net asset value (NAV) and traded at a premium (price goes above its NAV) because the underlying stocks had no updated prices to feed into the NAV calculation. Additionally, creations and redemptions could not be done due to the stock market being closed, as shown in Figure 1.5. We will explore creations and redemptions more in Chapter 3 and premiums in Chapter 5.

Figure 1.5 EGPT’s Price and NAV Graph with Flows at Bottom

      Source: Bloomberg

      The most recent example was in Greece, where the stock market closed for a few weeks in July as the country was in a debt crisis. Meanwhile, the Global X FTSE Greece 20 ETF (GREK) continued to trade about triple its average volume. When it finally came down, it was very close to what the stocks were priced at when they opened.

      The idea that you can invest in, trade or simply monitor an ETF even though the markets the ETF tracks are experiencing issues, can be helpful in terms of pricing and portfolio management.

      Fiduciary Vehicles

      ETFs have to be approved by the Securities and Exchange Commission (SEC) and most, like mutual funds, are regulated funds under the Investment Company Act of 1940. This means they have to have an independent board of directors and that the manager of the ETFs has a fiduciary obligation to act in the best interest of the fund holders. This is in contrast to other institutional vehicles such as swaps, futures, and other bank-issued vehicles including structured products.

      This can be very important to some institutions that have mandates that forbid them from using the aforementioned derivatives.

      “It is always nice when you have a pretty prospectus wrapped around an idea. It has all the disclosures and has gone through a vetting process [with the SEC]. There is good governance around the product. It is a nice, neatly wrapped package that can give asset managers a nice turnkey way of getting exposure.”

Ben Fulton, Elkhorn Capital Group

      One quick note, though: Not every ETF is registered under the 1940 Act, and some aren’t even “funds” at all. However, those products only have about 4 percent of the assets. We will further examine the specific differences in structures in Chapter 5.

      Battle Proven

      ETFs have been around for over 23 years now and have lived through numerous traumatic market events, including the Internet bubble bursting, the attacks on 9/11, the 2008 financial crisis, the flash crash, the taper tantrum, and countless market spasms. Their assets continued to grow after these events.