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

Figure 2
Offer
NAV Proxy
Bid
Using The Every-15-Second NAV Proxy
To Determine Bids and Offers
A B C D E
15sec 15sec 15sec 15sec 15sec
Time
temporaneous with the futures markets. Since the change to
a formal close at 4:00 p.m., ETF volume between 4:00 p.m.
and 4:15 p.m. has not changed materially. On May 15, 2009,
the day before this article was prepared for submission, ETFs
were four of the five most active issues in after-hours trading.
One of that day’s most active after-hours ETFs is based
on an index that does not have an active futures contract.
ETF Intraday Net Asset Value Proxies
When trading began in the first ETF introduced in the
United States (the S&P 500 SPDR launched in 1993), the
Securities & Exchange Commission (SEC) required that the
sponsors of the SPDR arrange for dissemination of an intraday
share value proxy for the SPDR at 15-second intervals. These
proxies are usually called indicative optimized portfolio values
(IOPVs). The requirement for publishing these values was
extended to every domestic equity ETF launched since 1993
and, with modifications, to ETFs holding foreign equities,
fixed-income instruments and other financial instruments.
In spite of improvements in trading data calculation
technology and the introduction of ETF portfolios that hold
infrequently traded securities, calculations of these intraday
value proxies are still based on the most recent trade of each
portfolio component. Matt Hougan discusses the inadequacy
of last-sale value proxies in an article scheduled to appear
in the July 2009 issue of ETFR. These intraday value proxy
calculations are made and/or disseminated by the National
Securities Clearing Corporation (NSCC) and other service
providers to “support” intraday trading of ETFs.
Professional ETF traders and market makers do not use
the “official” every-15-second proxy value calculations to help
them determine their ETF bids and offers. Professionals develop
their own valuations or subscribe to real-time ETF value calculations
based on contemporary bids and offers rather than
last sales. The fact that they do not use the free IOPV does not
mean that these professionals lack faith in the NSCC’s ability
to calculate correct values. The simple facts are that the last
sale is not a reliable indicator of contemporary values in most
Price
market situations, and the 15-second interval between valuations
is too long for the values to be useful to a trader.
Because an ETF is a derivative security, its current value
changes every time the value of any component of the ETF
portfolio changes. The ETF value proxies used by professional
traders are calculated from the midpoint of the bid and
offer for each position in the ETF portfolio. Sometimes the
value calculations made by and for professionals use the size
of bids and offers and the pattern of “changes” to forecast
short-term trends. Figure 2 illustrates how a naive investor
might attempt to use the “free” intraday proxy information
to develop a bid or offer for ETF shares.
In Figure 2, the latest IOPV is represented by a dot at
the beginning of each of the five 15-second intervals illustrated.
Investors might place limit orders at prices close to
the most recent per-share value proxy. Columns A through
E illustrate how bids and offers entered at equal distances,
respectively, below and above a sequence of these every-15-
second net asset value (NAV) proxy calculations might become
transactions—but not always the transaction that the investor
entering the order hoped to achieve. An offer to sell the ETF’s
shares slightly above the proxy value posted at the beginning
of time interval A would probably be lifted as the fund portfolio
value rose during intervals A and B. That offer was below
the changing per-share proxy value by the time that value was
updated at the beginning of interval C—less than 30 seconds
after the order was entered. The offer was also below the
likely bid in the market at that time. Of course, some of the
last-sale prices used to calculate each 15-second proxy might
be more than a few minutes old at the time the calculation
was made. Using the free 15-second values can be costly, but
even if investors had access to proxy values based on every-
15-second midpoints of bids and offers and could enter orders
as soon as the value was published, a lot can change before or
shortly after the next proxy value is published.
In my experience, many investors are aware of the existence
of the every-15-second last-sale NAV proxy value, but
few know how to find it for a particular ETF and even fewer
think about how, if at all, to use it. It is probably a good thing
that these proxies are not widely used. Any attempt to use
them to manage an order is more likely to lead to disappointment
than to a good execution. The information on share values,
transaction prices, bids and offers summarized in Figure
1 indicates that ETF bid and offer updates are published
more frequently than every 15 seconds (every time portfolio
component bids or offers change materially), making the ETF
share bids and offers a much better indication of the current
market for an actively traded ETF than the every-15-second
last-sale proxy calculation could possibly be.
The posted ETF bids and offers also have the advantage of
being something you can trade with. You cannot trade with
the every-15-second NAV proxy because it does not represent
a bid or offer for the ETF shares. An investor can be confident
that, even if his market data vendor is a bit slower and updates
quotes less promptly than the best data vendors, he will not
be seriously disadvantaged relative to other retail market participants.
Bids and offers for the most actively traded ETFs tend
both to be tighter and to change more frequently than stock
26
July/August 2009