11

I recently read through Graham's The Intelligent Investor and am looking at what index ETFs or Index Mutual Funds it makes sense for me to invest in. As I was considering this I realized that, at least as I understand ETFs, some of the principles from value-based investing still may need to be considered. As such I am wondering how to determine whether an ETF is trading at a good value?

As I understand it, when I contribute to a open-end mutual fund, I buy at a rate determined by the current value of the holdings of the fund, and more shares in the fund are simply created if needed, so it should accurately reflect the underlying value of the assets.

ETFs are traded like stocks and have a more fixed share count. Thus, I imagine their price has potential to diverge from the underling value of the stock assets indexed. The fourth point on this answer of why index mutual funds may be preferable to ETFs seems to corroborate my suspicion. This would seem to make ETFs more risky than index funds?

Assuming the above is all correct, how do I assess whether an ETF is undervalued or overvalued?

NOTE: I do not know whether this question needs to be specific to index ETFs or whether the same advice is good for all ETFs.

1
  • Have you considered that some indices may take a more value based approach than other indices here?
    – JB King
    Mar 7, 2014 at 6:16

2 Answers 2

9

You seem to be assuming that ETFs must all work like the more traditional closed-end funds, where the market price per share tends—based on supply and demand—to significantly deviate from the underlying net asset value per share. The assumption is simplistic.

What are traditionally referred to as closed-end funds (CEFs), where unit creation and redemption are very tightly controlled, have been around for a long time, and yes, they do often trade at a premium or discount to NAV because the quantity is inflexible.

Yet, what is generally meant when the label "ETF" is used (despite CEFs also being both "exchange-traded" and "funds") are those securities which are not just exchange-traded, and funds, but also typically have two specific characteristics: (a) that they are based on some published index, and (b) that a mechanism exists for shares to be created or redeemed by large market participants. These characteristics facilitate efficient pricing through arbitrage.

Essentially, when large market participants notice the price of an ETF diverging from the value of the shares held by the fund, new units of the ETF can get created or redeemed in bulk. The divergence quickly narrows as these participants buy or sell ETF units to capture the difference.

So, the persistent premium (sometimes dear) or discount (sometimes deep) one can easily witness in the CEF universe tend not to occur with the typical ETF. Much of the time, prices for ETFs will tend to be very close to their net asset value. However, it isn't always the case, so proceed with some caution anyway.

Both CEF and ETF providers generally publish information about their funds online. You will want to find out what is the underlying Net Asset Value (NAV) per share, and then you can determine if the market price trades at a premium or a discount to NAV.

Assuming little difference in an ETF's price vs. its NAV, the more interesting question to ask about an ETF then becomes whether the NAV itself is a bargain, or not. That means you'll need to be more concerned with what stocks are in the index the fund tracks, and whether those stocks are a bargain, or not, at their current prices.

i.e. The ETF is a basket, so look at each thing in the basket. Of course, most people buy ETFs because they don't want to do this kind of analysis and are happy with market average returns. Even so, sector-based ETFs are often used by traders to buy (or sell) entire sectors that may be undervalued (or overvalued).

1

You can follow the intra-day NAV of an ETF, for instance SPY, by viewing its .IV (intra-day value) ticker which tracks it's value.

http://finance.yahoo.com/q?s=spy

http://finance.yahoo.com/q?s=^SPY-IV

Otherwise, each ETF provider will update their NAV after business each day on their own website.

https://www.spdrs.com/product/fund.seam?ticker=spy

1
  • At time of post, SPY is $188.18, SPY.IV is $188.13, so it's overpriced by .05 cents. Arbitrage that. Mar 7, 2014 at 4:10

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.