How to Kill a Black Swan Remy Briand and David Owyong ...

Gastineau continued from page 31
the economics of their business is based on volume and risk
management. Most of them welcome the introduction of
NAV-based trading because it will substantially increase trading
volumes in ETFs that are not actively traded today. These
market professionals will earn far more from small profits on
a lot of trades than from much larger profits per share on
very few shares traded. NAV-based trading also gives market
makers an additional way to reduce their ETF inventory risk
without incurring the costs of frequent creation or redemption
transactions in lightly traded ETFs.
While the conventional ETF market usually works well for
investors who know how to use it to trade the largest and
most actively traded ETFs, it does not serve investors in less
actively traded funds very well. Trading costs are high and
hard to measure in the conventional market for less actively
traded ETFs. When an ETF’s trading volume is low in the conventional
ETF market, its bid/offer spreads are often wide,
and professional traders have little choice but to respond
opportunistically to retail orders rather than to arbitrage
pricing relationships.
NAV-based trading increases the opportunity for ETFs based
on newly developed indexes to compete with ETFs based on
established benchmark indexes. It makes trading easier for
advisers who are used to buying mutual fund shares at net
asset value. In an extension of trading services, we anticipate
the availability of executions based on dollar amounts and fractional
shares provided by a financial intermediary to reduce ETF
trading costs for defined contribution plans and other accounts
that make frequent small transactions. NAV-based trading will
facilitate the development of nontransparent ETFs that offer
active portfolio management and nontransparent indexes that
are not plagued with high composition change costs—in an
ETF structure that protects shareholders from the cost of other
investors’ fund share purchases and sales.
In an earlier paragraph, I noted that there is statistically
significant evidence that the average stock trades at a lower
price near the market opening than near the close on the
same day. A fund net asset value can be calculated from
opening prices as well as from closing prices. If there is
demand for it, NAV-based trading around opening or hourly
portfolio values as well as the traditional end-of-day NAV
calculation is possible.
The author gratefully acknowledges helpful suggestions from
the editor, Matt Hougan; participants at the NASDAQ OMX
Symposium on Exchange Traded Funds at New York University’s
Stern School of Business; and the Nasdaq OMX for the preparation
of Figures 3 and 4.
Endnotes
1 Net-asset-value-based trading is covered by two U.S. patents and a number of pending patent applications.
2 Individual investors probably follow similar trade patterns in stocks. The previous comments reflect conventional wisdom, not a systematic study of the underlying cause.
3 For discussion of these patterns and references to other research that has found similar patterns, see Heston, Steven L., Robert A. Korajczyk, and Ronnie Sadka, “Intraday Patterns in
the Cross-Section of Stock Returns,” March 18, 2009. http://ssrn.com/abstract=1107590. We will return briefly to the issue of intraday price patterns at the end of the article.
4 One of the best articles describing this data is by Hougan, Matt, “ETFs, Spreads and Liquidity,” Journal of Indexes, July/August 2008, pp. 30–33. See also one of Hougan’s blogs
comparing spreads in October 2007 and 2008, http://www.indexuniverse.com/component/content/article/31/4768-etf-spreads-widen-substantially.html?Itemid=3. The Index
Universe website, www.indexuniverse.com, lists monthly ETF average spreads. Click on Section and then on Data.
5 Do not rely on the published IOPV for any purpose.
6 They will use their proprietary value calculations to estimate NAV, not the posted IOPV.
7 The most important paper on ETF trading premiums and discounts is Robert Engle and Depojyoti Sarkar, “Premiums-Discounts in Exchange-Traded Funds,” Journal of Derivatives,
Summer 2006, pp. 27–45. This paper was reprinted in Bruce, Brian R., A Guide to Exchange Traded Funds and Indexing Innovations, Fall 2006, pp. 36–54. Engle and Sarkar found
that ETFs holding domestic stocks had an end-of-day average premium of the closing price over the reported NAV of just +1.1 basis points (a discount would be reported as a
premium with a negative sign). However, this tiny average premium is misleading. The average standard deviation of the last trade premium was 42.1 bps with a range of 17.6 bps
to 142 bps for various funds. A 42-bp standard deviation is more than four-tenths of a percent of the value of the fund share. Using this standard deviation as a rough indicator
of the cost of an MOC execution neglects the effect of “last” transactions that occurred before or after 4:00 p.m. Nonetheless, the average bid-asked spread for these domestic
stock ETFs at the close was 37.7 bps. Neither this spread nor the reported premiums and discounts provide a useful indication of the price an investor should expect on an MOC
transaction today. The study was based on a set of data that ended in September 2000. The procedures for trading ETFs around the market close have changed in a number of
ways since then. The domestic stock ETFs that Engle and Sarkar studied now trade tens of millions of shares daily, but today’s less actively traded ETFs display the same variability
of premiums and discounts found in the earlier data. A similar study of contemporary trading in less active ETFs would make interesting reading.
Callin continued from page 37
Looking forward, what seems almost certain is that investors
will demand transparency both in terms of the risk
exposures in the alpha strategy and the collective portable
alpha approach—and invest only in strategies where they
have a good understanding of the combined risk exposure,
the associated investment rationale and also the downside
risk over their investment horizon. The end result may be
that investors migrate out of some types of portable alpha
strategies and into others.
The fundamental value of portable alpha is still very much
alive and well—and approaches that meet key criteria as highlighted
in Figure 5 are likely to provide powerful results to
long-term investors prospectively, from both return enhancement
and diversification perspectives. In particular, given the
extraordinary level of yield premiums available from very-highquality
fixed-income assets currently, investment-grade fixedincome-based
collateral alpha strategies may provide longterm
investors with attractive returns in the coming years.
This article contains the current opinions of the authors but
not necessarily those of Pimco.
Endnote
1 Source: Pimco. Analysis performed using data from the eVestment Alliance US Large Cap Core Equity universe.
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