The selloff causes stress cracks in ETFs, with many tumbling below NAV. Worst hit are emerging...

The selloff causes stress cracks in ETFs, with many tumbling below NAV. Worst hit are emerging markets ETFs like the EEM which yesterday slipped to a 6.5% discount. "We are unable to take any more redemptions today ... a very rare occurrence due to capital requirements - we are maxed out on the amount of collateral we have out," emailed a Citi trader to counterparties. ETF losses were "far beyond what the most sophisticated financial risk models could have predicted," says Bryce James of Smart Portfolio. Where have we heard that before?

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Comments (6)
  • Whitehawk
    , contributor
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    NAVs will readjust over time and these funds will be back in balance. The market is selling the vehicle (shell) as an expectation that the index makeup will fall in NAV. This perception may be wrong or right, but is due in part from the uncertainty over the BRICs and other countries whose stocks are in the index (e.g. SK, Taiwan). Of course, this means all countries (or stocks) represented in the index are painted with the same brush, a common criticism of ETFs.
    21 Jun 2013, 10:28 AM Reply Like
  • RS055
    , contributor
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    ETFs are different to Closed End Funds. ETFs main claim to fame is that they track their underlying precisely, which is why people have become comfortable using them in all kinds of hedged strategies. The way ETFs ensure that the price tracks the underlying exactly is through the mechanism to create and redeem shares. Large banks called designated participants have the right to create /redeem ETF shares and the the existence of this easy arbitrage keeps the price in line.
    Therefore, it is very significant that ETFs are trading at discounts to the underlying. It means that the ETFs are unable to deliver the underlying to designated participants - so redemptions are becoming difficult. reflects illiquidity.
    Probably blows up a lot of hedged strategies.
    21 Jun 2013, 12:06 PM Reply Like
  • ThetaDecay
    , contributor
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    And what happens when these hedged strategies start to blow up? Forced selling, widening the divergence. The same thing happened to LTCM when their assets started to stray from historical correlation and their spreads moved against them. Hopefully there will be less systemic risk with these ETFs.
    21 Jun 2013, 04:49 PM Reply Like
  • Whitehawk
    , contributor
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    LTCM was leveraged over 100x, well over, on some trades. It also made large directional bets that were not offsetting, and it doubled down (martingale style). It did not have a margin of capital to save itself when those trades failed. Not a 1-1 comparison. Evidently the liquidity of the ETF redemption process is important, and industry participants should work on that process if there are problems during heavy selling. Over a short period, a divergence from index or NAV is not the worst problem - the markets will eventually clear and balance.
    21 Jun 2013, 05:10 PM Reply Like
  • J Mintzmyer
    , contributor
    Comments (8200) | Send Message
    Might be a dumb question... but if there is a discount to NAV and the trading mechanism will eventually bring the price back in line, is this an arbitrage opportunity for a smaller investor?


    The strategy can be used for CEFs, but unfortunately many of them trade at extreme discounts for multiple years-- especially the foreign ones (CHN, IFN, GF), so any 'arbitrage' might never occur. It seems ETFs would adjust in a few days? Or would the adjustment just be a lowering of the NAV?
    22 Jun 2013, 04:33 PM Reply Like
  • Whitehawk
    , contributor
    Comments (3121) | Send Message
    Answer is yes, and we saw this on Friday when EEM and VWO were up on the day. The trough-peak was about 2.7%, so the retail profit oppty was limited. These oversold/overbought opptys are probably better for some CEFs - I certainly have made much more than 2.7% on a few of those trades. Because ETFs have risk arb market makers it is tougher and less profitable. As a matter of fact, ETFs trade above their NAV much more often than below, sometimes at huge differentials. I believe these cases present better opptys.
    22 Jun 2013, 05:40 PM Reply Like
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