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A primer on ETF valuation

  • Wiley Global Finance WILEY GLOBAL FINANCE
  • Exchange-Traded Funds
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It is important to understand the different types of valuation mechanisms for ETFs, the nuances of each, and how to use them to get the best execution on your ETF order. We begin with the calculation of the net asset value (NAV) of the funds and then explore discounts and premiums and cash amounts, ending at the calculation of the intraday indicative value (IIV).

The structure of the ETF is based on holdings transparency. One of the keys to being transparent is publishing all of the numbers required to calculate the fair value of an ETF. Five elements involved in the valuation of an ETF are published every day:
 

  1. Net asset value: The most recent official value of the ETF based on most recent market close.
  2. Intraday indicative value: The calculation of the most recent value of the fund based on market prices of the underlying securities.
  3. Total and estimated cash: The total and estimated cash amounts are the amount of excess cash in the fund. These numbers are used to calculate how much balancing cash will be required when doing a creation or redemption.
  4. Shares outstanding: The shares outstanding of the fund are how many shares have been issued and can change daily with creations and redemptions.
  5. Accrued dividends (certain funds only): The dividends collected from all the companies in the index and normally paid to investors quarterly.
     

Trading Tip

You can access any of the relevant data about ETFs by using this ticker methodology. Change "ETF" to the ticker of the fund you are monitoring.

ETF Ticker Conventions Moniker Bloomberg Google Finance, Yahoo Finance, Reuters, Others
Net asset value NV ETFNV ETF.NV
Intraday indicative value IV ETFIV ETF.IV
Total cash TC ETFTC ETF.TC
Estimated cash EU ETFEU ETF.EU
Shares outstanding SO ETFSO ETF.SO
Accrued interest DV ETFDV ETF.DV

Calculating Net Asset Value

The NAV of an ETF is a daily calculation that is based off the most recent closing prices of the assets in the fund and an actual accounting of the total cash in the fund at the time of calculation. This gives the fund a standardized value that can be compared to other funds for performance statistics and accounting. The fund world is based on comparative statistics, so uniform reporting was critical in the development of ETFs.

The NAV of the ETF is calculated by taking the sum of the assets in the fund, including any securities and cash, subtracting out any liabilities, and dividing that by the number of shares outstanding.

NAV = sigma-17 (Assets-Liabilities)/Shares Outstanding)

All of these data points are provided on a daily basis, including exactly what the fund is holding. This transparency frequently is touted as a major benefit of an ETF. Mutual and closed-end funds are not required to provide portfolio holdings on a daily basis. A mutual fund provides a daily NAV but holdings are released quarterly. A closed-end fund provides an NAV either daily or weekly with holdings released usually quarterly. In an ETF, you are able to see the exact assets and aggregate liabilities of the fund at any time. This is also a factor which has worked to prevent against style drift in the products.

Another way to calculate the NAV of an ETF is to use the creation unit (CU) and total cash published daily. The CU is a set of shares or securities in the ETF that constitute one unit of the fund. One creation unit is the denomination of underlying assets that can be redeemed for a certain number of ETF shares.

NAV = sigma-17 (Shares per each component stock x Last Price)/CU Shares + Total Cash/CU Shares

In order to calculate the actual value of the ETF at any time during the day, you would utilize the available creation unit. The creation unit is utilized for building any model around ETF pricing. It shows the exact basket that must be delivered to the issuer in order to receive ETF shares during a creation.

The NAV of an ETF is represented in share price terms. This is why you would be dividing the asset totals by shares outstanding and the creation unit calculations by the creation unit share amount.

Cash and Estimated Cash

For the standard equity ETFs, there are two cash numbers published daily, the total cash and the estimated cash. The quoting ticker conventions are TC and EU respectively. These are published as actual amounts in dollars per creation unit. For a fund showing a total cash number of $1,000 and having 250,000 shares outstanding with a 50,000 share creation unit size, the total amount of cash in the fund is $5,000. This would be calculated with the equation:

Cash in Fund = Shares Outstanding/CU Shares x Total Cash

Since the NAV of an ETF is reflected as a price per share, you will use the total cash number converted to a per-share amount. This is arrived at by dividing the total cash amount by the creation unit shares amount:

Cash per ETF Share = Total Cash/CU Shares

The total cash number is backward looking to ensure that creations and redemptions occur at NAV. When the fund is being traded throughout the day, the estimated cash amount is used to indicate how much cash the fund will require for the creation or redemptions. When calculating the IIV or an estimated NAV (eNAV) of an ETF, the estimated cash number should be used. This number takes into account potential dividends, management fees, and other potential cash and portfolio changes in the basket. Then the following day, when determining the exact requirements of cash movement between the issuer and the AP, the total cash number is utilized.

Discounts and Premiums

A common misperception that arises around the NAV is the discount and premium calculations for a fund. The importance that investors place on this number is a holdover habit from looking at the prevalence of premiums and discounts in closed-end funds (CEFs). The two types of funds are listed, and the fund prices trade independently of NAV; however, the premium and discount numbers are completely different in meaning. There are occasions where persistent premiums and discounts arise in ETFs, but that is due to a structural inconsistency. Typically any discount or premium pattern for an ETF will be very short-lived as the arbitrage function enables its collapse in the near term.

Under normal circumstances, the premium and discount that arises between an ETF NAV and its trading price at the end of the day is the result of late market activity and will narrow on the following open. This is true of ETFs with constituents that trade in the same time frame.

Many circumstances can and will push an ETF away from its NAV at the very end of the day, causing it to trade at either a premium or a discount compared to the basket. It could be that a large order came into the ETF at the very end of the trading day too late, or too large, for the arbitrage functionality. Additionally, as the trading day ends, spreads typically widen to prevent the occurrence of exposures that will have to be held overnight. This can cause late prints in ETFs to be somewhat erratic and can create the impression of a premium or discount versus the NAV.

Trading Tactics

When trading, you should try to avoid trading the ETF too close to the market open, before the underlying constituents have all opened. While it is intuitive to wait until the domestic underlying constituents are open before trading the ETFs, it is also valuable to wait until the correlated hedge of international ETFs start trading with full liquidity before trading those as well. This should explain why you see spreads in many names tighten a few minutes after the open. Also, as the trading day draws to a close, ETF liquidity providers have the risk that they will not get completely filled in a basket and would have to carry overnight positions that are not perfectly hedged. This is why spreads widen near the close. There is more risk to providing liquidity at that time.

Calculating Intraday Indicative Value

Although the NAV is important for the calculation of prior end-of-day valuation statistics, the IIV is critical for bringing you a step closer to the actual trading value of an ETF during the trading day. It is important to distinguish what this number actually is for two reasons:

  1. It goes by several different names.
  2. At certain times during the day, it loses its relevancy because of trading anomalies as discussed previously.
     

The IIV is also sometimes known as the intraday indicative value (IOIV) or the indicative net asset value (iNAV). IIV is becoming the mainstream name because this is the one used for quoting conventions. The ticker quoting convention is IV appended to the ticker: for example, ETFIV or ETF.IV or ETF IV, depending on the system.

The IIV represents the most recent trading value of the assets of a creation unit. This number is designed to give investors and traders an almost real-time indication of the value of the assets underlying the ETF throughout the trading day. It is a tremendous idea that is unique to the structure of ETFs and is useful for ETFs with underlying baskets of stocks that trade at the same time as the ETF in the market.

The IIV typically published at a frequency of every 15 seconds, which is why I call it almost real time. (Some firms are starting to make the number available to clients in real-time form.) A lot can happen in 15 seconds that makes the number more relevant as a guide than a mandate. If the funds price has moved slightly away, it probably would be a function of delayed quoting frequency of the IV rather than an erratic movement in the ETF price itself.

The five steps for calculating the IIV are:

  1. Use the CU to get the proper share quantities for each stock in the basket.
  2. Multiply the last price of each stock by its representative share amount in the CU.
  3. Sum the products to calculate total assets of the fund.
  4. Divide this by the amount of shares per CU of the ETF.
  5. Add to that the estimated cash value divided by the amount of shares per CU of the ETF.
     

IIV = sigma-17(Shares per each component stock x Last Price)/CU Shares + Estimated Cash/CU Shares

The IIV is the implied value of the ETF as calculated by the most recent trading prices of all the stocks in the basket. This value is calculated completely independently of the actual trading price of the ETF in the secondary marketplace. However, in a U.S.-listed ETF with a basket of domestic stocks underlying, those two independently generated values should trade in parity with one another because of the open conversion between the basket and the ETF.

This is one of the core functionalities of the creation and redemption mechanism of the product wrapper and the one responsible for eliminating discounts and premiums. In many high-volume ETFs, a quote for the IIV and a quote for the ETF should be at parity with each other. Differences could be because of the time lag and other occasional structural nuances. Since stock (and therefore ETF) trading now takes place in microseconds, a lot can happen in between two separate 15-second quotes. Professional traders are not using published IIVs as a basis for trading. Most, if not all, desks that are trading ETFs are calculating their own IIVs based on real-time quotes in the underlying baskets that they are generating within their systems. They will see their own IIV calculation in real time so they can act on pricing at the same frequency as their competitors.


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Article copyright 2011 by David J. Abner. Reprinted and adapted from The ETF Handbook: How to Value and Trade Exchange-Traded Funds with permission from John Wiley & Sons, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments® cannot guarantee the accuracy or completeness of any statements or data. This reprint and the materials delivered with it should not be construed as an offer to sell or a solicitation of an offer to buy shares of any funds mentioned in this reprint.
The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Fidelity is not adopting, making a recommendation for or endorsing any trading or investment strategy or particular security. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before trading. Consider that the provider may modify the methods it uses to evaluate investment opportunities from time to time, that model results may not impute or show the compounded adverse effect of transaction costs or management fees or reflect actual investment results, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.
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