It's the promise that has helped propel the exchange-traded fund business into a $1 trillion industry: that an ETF's price will accurately reflect the values of all the stocks, bonds, commodities or anything else stuffed into it. But it seems that ETF manufacturers are having a really difficult time living up to that ideal.
Indeed, according to a new study by New York University, ETFs often trade at up to a 1 percent premium (or discount) to the investments they hold. That 1 percent might not sound like a lot, but it's higher than the average 0.6 percent annual expense ratio for ETFs. When it's a premium, "the unsophisticated investor may face an unexpected additional cost when trading ETFs," says Antti Petajisto, the study's author.
The mispricing boils down to three things: the type of assets held in the ETF, how often those assets trade and the types of price swings those assets endure. Foreign stock ETFs have a rough time staying close to the prices of illiquid foreign stocks. But ETFs tracking U.S. municipal bonds are also offenders. The iShares S&P National AMT-Free Municipal Bond fund (MUB)
Petajisto says a savvy investor could bet that an ETF's price will eventually match the underlying investments, but profiting from such moves would require a lot of capital and rapid-fire trading abilities many individual investors don't have. For most investors, Petajisto says, the best strategy is to not buy or sell the ETF on a day when its underlying assets have big price swings.
For their part, ETF firms say the findings don't clash with the industry's promise. "ETFs are the best go-to vehicle, even when they have to trade during periods of stress," says Daniel Morillo, head of investment research at iShares. But iShares, which is owned by BlackRock, doesn't dispute the findings either. In fact, the firm hired Petajisto shortly after he finished working on the study.