WHEN placing a trade, investors understandably concentrate on making the decision that will yield the most profitable returns. But it is just as important for traders to understand how they are investing as well as what they are investing in.
This is particularly relevant for investors using exchange-traded funds (ETFs) – knowing how an ETF is priced and the different ways in which you can value it can help you make more timely and better informed trading decisions.
Since ETFs are listed and traded on exchanges like stocks, each one has a bid/ask price, which is affected by supply and demand forces and which also reflects the current value at which an investor can buy or sell shares in an ETF. The spread between the bid and the ask generally reflects the average spread of the underlying securities that comprise the ETF, as well as the traded volume and the number of market makers.
However, while price is ultimately important in the buying or selling a share of an ETF in the secondary market, investors would be wrong to focus on price alone and should use complementary valuation methods.
If you are looking at the ETF’s performance over time relative to the underlying index, then you definitely need to look at net asset value (NAV), says Nizam Hamid, head of sales strategy at iShares, BlackRock’s ETFs division.
The NAV of a fund is the value of each share measured by the value of its underlying holdings, and is calculated using the closing prices of the underlying securities on their respective exchanges. NAVs are particularly useful when evaluating funds with international exposures.
Global markets are open at different hours so the NAV and the closing price will reflect the fund’s value at different points during the day. The NAV is calculated using the last closing price on the relevant exchanges, wherever they happen to be, whereas the closing price of an ETF listed on the London Stock Exchange reflects the fund’s last traded price in London.
However, investors should remember that many ETFs distribute dividends. Assuming no market movement, the NAV of such funds will tend to grow when the dividends are paid by the underlying securities and will then drop when the ETF holders are paid. If you are looking at the historical performance of an ETF relative to the underlying index, you should use the adjusted NAV to get the most useful comparison. Adjusting for a dividend distribution will have a significant impact on your return over time. If you own shares in an accumulating ETF, which reinvests the dividend, the adjusted NAV is less critical to your performance analysis.
Since the NAV of an ETF is calculated by using the closing prices it is not representative of the value of a fund over the course of a day. Investors who need more precise, up-to-date information should use a different measure of NAV – the intraday net asset value (iNAV).
This is a measure of the continuous real-time, fair-value of an ETF calculated by Deutsche Boerse. When the underlying securities are available to trade, their continuous share prices are used. When these markets are closed, the iNAV is an indication of where the global markets will trade rather than a firm calculation and it will reflect where the futures markets are suggesting the price for each stock. They are available on Deutsche Boerse, Bloomberg, Reuters and other data vendors.
The iNAV gives the ETF added transparency and credibility and allows investors to value the fund in real time, which is important if you are day-trading and looking to enter and exit the market at very precise points. Compare this with the bid/ask price to see if the ETF is being priced fairly.
Whether you are an individual accessing exchange-traded funds through your broker or independent financial adviser or an institutional investor, evaluating an ETF’s performance is a crucial stage of placing a trade. Retail traders will be focused on how well the ETF reflects the benchmark, whereas institutional traders will be more interested in how efficiently the ETF performs compared to other trading vehicles such as swaps and futures.
While choosing which ETF to trade is most of the work, taking time to evaluate its performance using a number of different metrics will ensure you don’t get disadvantaged when it comes to actual trade.