Index ETF and Liquidity Risk

[RBRubicon]

Hello Guys,

I'm new to this forum and this is my first post. I have a question and did use the forum search, but didnt find any thread in which this problem is discussed before, so I hope this thread is not superfluous at all.

We all know the Alliance Bernstein Article about liquidity risks of passive ETFs. I would like to understand the mechanics behind the depicted scenario of an Index-ETF. The scenario is:

The plunge in global equity markets on August 24 was a case in point, when US exchanges halted trading in certain stocks that morning. But many ETFs continued to trade, and without good pricing information, 10 of the largest equity ETFs traded at a steep discount to their underlying value. In other words, the ETFs’ prices collapsed far more than the prices of their underlying securities. If you had tried to sell during that period, you could have experienced a significant loss.

So in short:

• You bought an index ETF e.g. on the SPX (or any arbitrary index else).
• Some of the underlying stocks are suspended from trade (but not all).

What I want to know is:

1. Hows the Index calculated while some of the stocks are suspended from trading? Are they just putting the last valid price of theese stocks into the calculation?
2. If thats so, the index-ETF-price is differing from the calculated index, cause the suspended stocks are still priced in the index ETF. Compared to a basket of stocks imitating the index - which enables you to firesale at least the liquid stocks - would you consider the the liquidity risk of ETFs as signicicant?

I hope my questions are not too stupid for you guys.

RBR

 

[rmorse]

I have not read the article from AB yet, but they sell mutual funds and portfolio strategies and have a vested interest in moving investors away from ETFs. I would weight any white paper funded by anyone with an agenda.

 

[RBRubicon]

Ah okay. I thought because Larry Fink responded negatively to it and I heard Carl Icahn mentioning it somewhere in an interview, the article would somehow be quite well-known.

But it doesn't matter anyways, because the questions posted above are of interest for me despite the article. What happens in that scenario if underlying stocks get suspended with the index and the index ETF? Any considerations?

 

[rmorse]

Stocks can be removed or added to the ETF. Also, the ratios can change. I don't see it as an issue. Any more specific question can best be answered by the firm that runs the ETF. Pick one, and give them a call.

 

[Sig]

Stocks can be removed or added to the ETF. Also, the ratios can change. I don't see it as an issue. Any more specific question can best be answered by the firm that runs the ETF. Pick one, and give them a call.

You know you do this a lot, answer without actually reading the question and as a result completely miss the point. Not trying to be a jerk, but it's at least mildly annoying and it doesn't help your reputation which is I'd guess is why you're answering all these questions in the first place.

To the OP, its not a stupid question, it's a very good one. The issue is exactly what you stated, when some of the underlying stocks in an ETF are halted, the NAV is based on the last trade price for those stocks. This is almost certainly not the market price, if it was there wouldn't have been a halt. This could theoretically happen in either direction, but so far its been in dramatic falls in the market so the ETF trades for lower than the published NAV. I don't think its fair to say this is a problem, per se. The ETF is actually trading at its fair value, its the NAV which is inaccurate. If you're a trader, its actually very helpful to be able to maintain some exposure to the market even when a large part of it is in trading halts, otherwise you'd be stuck until the halts were lifted.
If there is a problem it would be that the ETFs are effectively subverting the halt mechanism, so if you're really in favor of that you'd be concerned. Another potential issue may be that everyone trades the ETF down so that as soon as the halted underlying come out of halt they go right back in again as everyone tries to arb the NAV.