Q. So it seems that some of the plumbing behind ETFs has come under pressure lately, and there have been complaints about tracking error. So first, what is that?
A. ETFs hold specified baskets of securities, and the market generally matches up the price of the ETF itself with the total value of the securities it holds. If they get out of whack, firms called “authorized participants” either sell matching baskets for new ETF shares, or redeem existing ETF shares for baskets. That mechanism works well in calm, liquid markets, but we’ve seen lately that it doesn’t always work in volatile, thin markets.
Q. So there have been some discrepancies between the market prices of ETFs and their NAV?
A. That’s right. That doesn’t happen with mutual funds, which meet redemptions only once a day by selling fund assets. An advantage of ETFs is that you can ayou to cash out at any time during the day by selling the shares on the market… but now we see there’s no guarantee that the price you get will exactly equal the value of the securities the ETF holds: tracking error.
Q. Is this a widespread issue?
A. Not really, but that it’s been happening at all has made people focus on this somewhat weird plumbing behind ETFs. And we have to give some credit to Peter Tchir, who essentially predicted this might happen in the high yield bond space, precisely because it’s a less liquid market. But there have also been issues with munis and some ETFs holding foreign stocks, where tracking error is exacerbated by the fact the ETFS trade in NY while the markets for the underlying stocks are closed overseas.
Q. What’s the bottom line here?
A. Two points. 1. That investing in a thin or volatile market via an ETF won’t protect you from the volatility of those instruments. 2. Those who prefer ETFs to mutual funds because you can trade them at any moment — rather than just at day’s end –may not understand how they work. If you’re doing that to be able to jump out amid market turmoil, you need to recognize this tracking error possibility.