Teacup-Sized Tempest: EEM Discount to NAV

In my recent “Look What Has Emerged” article, I promised you a follow-up in which I describe one recent irregularity (actually more similar to an idiosyncrasy) within the trading of iShares MSCI Emerging Markets Index (EEM) on Thursday, June 20th.  The Financial Times transformed this irregularity into an article filled with attention-getting details, pieced together into such a way as to      -suggest that the activity within EEM was not only surprising and suspicious, but perhaps illicit or criminal as well! The alarming nature of the article and the several misperceptions contained therein provide fertile ground for a brief lesson about ETF’s that hold securities outside the United States and the Americas!

First, what happened on June 20th?  As you recall, markets were in a roiling condition following Ben Bernanke’s reference in May to the dreaded “T” word (as in “taper” QE bond purchases). Domestic, foreign, and emerging market equities and fixed income securities were buffeted by higher than usual volatility. So the stocks within the EEM “asset universe” were both active and trading within a broader than normal range.

GRAPH: above you see the price movement in EEM between May 30 and June 28. As you can see, the slope of the trend was steepest on June 20, when EEM lost $1.50.

Within that context, the Times compared the net asset value (NAV) of EEM at the close of Wednesday’s New York trading with the closing price of EEM when New York trading ended on Thursday – declaring they found a 6.5% discount in EEM’s price versus its NAV!  Everyone will concede that 6.5% is a large number in equity pricing. However, the Times neglected a number of extremely pertinent facts:

1)    When we examine individual U.S. corporate equities, it is clear that analysts and investors alike can, at any give point during the day, agree that its “price” is $X-amount.  However, if we ask what “value” that stock has, you will get almost as many different answers as there are people answering (depending upon their preferred valuation method).

2)    On the surface, since an ETF is a stock, one could expect that a similar distinction would also apply. However, that is not the case, for at least three reasons:

a.   An ETF is a collection of separate equities, each of which has its own objective price during market hours;
b.   Unlike is the case with a stock, that at any moment has a fixed number of shares outstanding, the shares of an ETF can be “created” or “removed” by the ETF provider as demand dictates (in contrast, a “closed end fund” (CEF) has a steady number of shares outstanding);
c.   A foreign developed or emerging market ETF will be composed of many (sometimes all) stocks that trade in their “native markets” during hours that the New York (and other U.S. exchanges) are closed. So when “the U.S. Market” opens at 9:30 AM EDT, most of the EEM stocks are not being actively traded. Therefore, we have EEM shares moving up or down in price within U.S. markets quite independently of the “value” placed on component shares within the EEM during normal trading hours of the applicable emerging market!

Hopefully, you thereby see a couple of basic reasons that the Times’ analytical methodology was severely flawed. Comparing the “Wednesday NAV” with the “Thursday Closing Price” would be akin to comparing “night” with “day” (or “oranges” with “apples”).

How does the financial industry cope with this idiosyncrasy of foreign-oriented ETFs?  They describe this “market process” as a “Price Discovery” mechanism! Traders in the U.S. are bidding the price of EEM up or down based on whatever analysis they depend upon, because the actual NAV of EEM is static (“stale”) during U.S. trading hours. (Someday, when the world has moved to global 24/7 trading, this will no longer be an issue.) Therefore, the active (“dynamic”) market forces that move EEM up or down during U.S. trading hours anticipate future price moves in the related market(s) when those stocks resume trading!

BlackRock owns the huge “iShares” stable of ETFs (including EEM). Christine Hudacko is a spokesperson for Blackrock, and by way of addressing the “tempest” the Times’ article created, distributed this in an email: “Approximately 75% of the EEM basket is closed during the U.S. session. Thus 75% of the basket was not yet incorporating the negative market move during the U.S. session [on Thursday].”   She went on to suggest that the widening of the EEM spread on Thursday reflected the anticipation of a sizable fall in price the following day; and significantly, it was pointed out that the Times’ calculation was flawed – the discount to NAV was actually 2.6% instead of 6.5%!

I hope you see now why the Times’ seeming “tempest” was really just a “teacup-sized” tempest – not a full-blown tempest!

There is another lesson you can extract from this brief story – different firms use different methods of calculating NAV (wouldn’t you know!).  For example, although Vanguard’s big emerging market ETF (the Vanguard FTSE Emerging Markets ETF (VWO)) is based on a different index than EEM, VWO’s price dropped on Thursday almost as much as EEM’s – 4.3% to 4.5%!  However, the “discount to NAV” figures for the two ETFs were quite far apart (VWO’s was just 1.6% while EEM’s was the 2.6% number).  Isn’t that interesting!  Does that mean that VWO is “better”?  Not necessarily!

GRAPH: above, the price action of VWO is in red while EEM is in blue. The lines slope almost identically except for three days (June 24-26). So they lost about the same percentage on June 20th. However, VWO has a “fair value” NAV system. Therefore, its “discount to NAV” was not as high as for EEM.

The variance is accounted for by the fact that Vanguard (unlike iShares) adopted a “fair value NAV” methodology – which results in Vanguard updating the NAV on its overseas ETFs during U.S. hours on the basis of some of the “price discovery” we talked about earlier.  Yes, it sounds a little fishy, but it is perfectly legitimate because the “fair value” system is fully disclosed and transparent!

INVESTOR TAKEAWAY: whenever you purchase an ETF focused on an overseas market, you should be fully aware that the market processes and “price discovery” mechanisms involved with those ETFs are quite different (and more complicated) than for domestic shares. In addition, when you utilize data such as “discount to NAV”, be absolutely certain that you know how that NAV is calculated!

SIDE NOTE: Index-provider MSCI announced changes to the composition of the emerging markets index during the second week of June. To no one’s surprise, Greece has been dropped from the “developed market” index and plunked into the emerging market index. According to MSCI, Greece has failed to meet the criteria expected from developed country index members for (at least) two years!

DISCLOSURE: The author owns shares of EEM and VWO.  Nothing herein is intended as a recommendation to buy or sell anything. Consult with an advisor before making any investment decision.  Both graphs prepared through YahooFinance.com.

Submitted by Thomas Petty MBA CFP

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