In our current volatile market, there is a greater likelihood that events occurring after the close of foreign markets, but prior to the close of U.S. markets, will impact the valuation of securities. Specifically, funds that invest in international securities could be subject to market timers looking to take advantage of potential arbitrage between the time a foreign stock exchange closes and the time the U.S. stock exchange closes. The market timer buys into the fund and then sells out of the fund the next day, driving up costs and diluting the share value for long-term investors.
To combat market timing and minimize risk, funds can use a fair value pricing service that supplies an adjustment factor, accounting for events occurring after the foreign stock exchange has closed. Doing so can minimize the opportunity for arbitrage, but is a fair value pricing service right for an ETF?
Do Fair Value Adjustment Factors Make Sense for ETFs?
Using a fair value factor is useful for an open-end mutual fund where shareholders buy into the fund and redeem out using cash, but is it right for an ETF? Generally, the answer is no; however, there are gray areas worth considering.
Only authorized participants (APs) are allowed to subscribe or redeem creation units directly from the ETF. For all others who wish to purchase the ETF, they can only do so on the secondary market, where shares trade at market price. In the secondary market, the shares may trade at a premium or a discount. While it’s possible those trading on the secondary market may try to take advantage of arbitrage opportunities that occur between the closing of the foreign stock exchange and the U.S. stock exchange, their trading activity will have no impact on the remaining shareholders of the ETF.
As an ETF investment strategy typically tracks an index, APs typically subscribe to an ETF through a subscription-in-kind (and redeem out through a redemption-in-kind) of a basket of securities that mimics the underlying index whose return the ETF is trying to achieve. This helps lower transaction costs for the ETF. Following this scenario, the opportunity for arbitrage is decreased as the AP buys in with a basket of securities and then redeems out with the same basket of securities.
However, APs also may create and redeem shares with cash-in-lieu of certain securities, or purchase or redeem creation units entirely in cash. One might think that with cash-in-lieu or all cash transactions, APs might still have an opportunity to market time the ETF. However, in most cases the AP is charged a variable fee on cash transactions to cover certain brokerage, tax, foreign exchange, execution, market impact, and other costs and expenses related to the execution of the trades. This variable charge effectively mitigates any opportunity for an AP to market time an ETF. Therefore, it is generally considered unnecessary for an ETF to apply fair value pricing factors to combat market timing.
What Are the Financial Reporting Considerations When Using Fair Value Pricing Factors?
Another consideration in using fair value pricing factors is financial reporting. Under GAAP all investment companies are required to state their investments at fair value. Foreign stock market post-closing events, if not accounted for when the investment company strikes its NAV, could lead to a financial statement misstatement. The ETF should evaluate the impact of stock market post-close events and consider the need to adjust the values for financial reporting dates.
In general, it’s often unnecessary for ETFs to apply fair value pricing factors to combat market timing. However, to be in compliance with GAAP for financial reporting purposes, fair value pricing factors should be considered. The artificial tracking error between the ETF’s total return and the underlying index’s total return can be eliminated by using a service provider that adjusts the underlying index to account for significant events after the close of the foreign stock exchange.
Contact Jim Kaiser at email@example.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.