Saturday, January 7, 2012

Be careful when buying ETFs at premium to NAV

The start of 2012 saw a large spike in shares outstanding of a number of fixed income ETFs, particularly the high yield oriented funds. One of the largest high yield ETFs is the iShares HY fund managed by Blackrock known by its ticker symbol as HYG. Below is a chart showing the recent spike in shares outstanding.

HYG (HY ETF) Shares Outstanding (Bloomberg)

This spike in shares outstanding corresponds to over 6% or almost $700mm increase in market value of the fund. In the high yield bond market, that's a substantial number, particularly given that this is only one of several large HY ETFs (JNK is another large one). Some have interpreted this as an acceleration of capital inflows into fixed income funds. However the reality has more to do with liquidity than fund inflows.

At the end of 2011 HYG started trading at a premium to NAV as demand for yield outweighed the Europe fears. Typically dealers would arbitrage this premium by buying bonds (a basket of bonds that represents the ETF's holdings) in the market and delivering them to the manager in return for additional shares. They would then sell the new shares at a premium, capturing some of the difference between the ETF price and it's NAV. However as liquidity dried up at the end of last year, dealers could not locate the bonds they needed for this transaction. At the start of the new year, liquidity improved and the dealers were able to buy the bonds to create new shares. With all the new shares flooding the market, the price came down while the NAV came up (demand for the basket of bonds increased). As the chart below shows, the premium to NAV declined.  In effect the inflows into this ETF happened last year, while this year that capital is flowing into the bond market.

Market price vs. NAV (premium) for HYG (Bloomberg)

HYG is down 0.6% year-to-date due to this decline in premium, while similar high yield mutual funds that don't have the "premium" issue are up.  For example T.Rowe Price HY Fund (PRHYX) is up 0.8%. What this tells us is that share count is not necessarily an indication of current fund flows into ETFs, particularly when the underlying basket of assets is relatively illiquid. In this aspect ETFs are quite different from mutual funds. More importantly, one should be careful when buying ETFs that trade at a premium, even if the asset class looks attractive.  A mutual fund may be a better alternative.
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