Objective research to aid investing decisions

Value Investing Strategy (Strategy Overview)

Allocations for May 2024 (Final)

Momentum Investing Strategy (Strategy Overview)

Allocations for May 2024 (Final)
1st ETF 2nd ETF 3rd ETF

A Play on ETF NAVs?

| | Posted in: Fundamental Valuation

A reader asked: “Does buying Exchange-Traded Funds (ETF) currently trading below Net Asset Value (NAV) provide a real advantage in the long run? In other words, are they ‘bound’ to reach NAV at some point? Does buying a fund which is trading at a discount to NAV and shorting a fund within the same sector that is trading at a premium to NAV make sense?”

See “The Limits of Arbitrage: Evidence from Exchange Traded Funds”. The abstract of this paper states:

“Exchange Traded Funds (ETFs) consistently trade away from their net asset value. In violation of market efficiency, these discounts vary substantially over time and are found to be significant in the explanation of future returns. Returns to simple strategies which incorporate information in the variation of discounts outperform buy-and-hold strategies by an annualized 15%, net of transaction costs, but only expose the investor to about one fifth the risk. ETFs, on average, are found to be about 17% more volatile than their underlying assets; 70% of the excess volatility can be explained by proxies for transaction and holding costs which inhibit successful arbitrage. The findings in this paper are consistent with noise trader models of costly arbitrage and are inconsistent with hypotheses of financial market efficiency.”

The paper notes that:

  1. “The discounts may reflect for example the capitalization of future fund expenses or the relative liquidity of a fund to its assets.”
  2. “…these variations in discounts are predictive of future returns. I construct simple trading strategies using information in the discounts and show that, net of fees, these strategies outperform the market substantially. This does not, however, mean that the arbitrage strategies are risky, as they require holding the ETFs on average only 17% of the time.”
  3. “A trader’s strategy should purchase ETFs on very small discounts and sell them on very large ones. …a ‘smaller’ discount refers to a larger in absolute value discount or smaller in absolute value premium.”
  4. “The returns to such a strategy are lower cross-sectionally for funds with higher volumes and higher variation in discounts, and when the fund holds international securities.”

The author therefore employs a strategy that agrees with your hypothesis. Note that matching ETFs for a hedge strategy based on fund discounts involves more than matching the sector (excerpt 4).

The study employs data available through early February 2004, and ETFs are relatively young. New data may alter conclusions.

Daily Email Updates
Filter Research
  • Research Categories (select one or more)