Discounted ETFs Are Not Necessarily Bargains

NEW YORK (TheStreet) -- After Chairman Ben Bernanke talked about tapering the Federal Reserve's stimulus program, stocks and bonds cratered on June 20. With investors racing to sell, many ETFs traded at discounts to the value of the assets in their portfolios.

Emerging markets funds took particularly hard hits, with some selling at discounts of more than 6%. Some municipal funds posted discounts of more than 2%. Since then, prices have recovered, but many ETFs still trade at discounts. Funds that trade at discounts of more than 1% include iShares MSCI Emerging Markets ( EEME) and SPDR Nuveen S&P High Yield Municipal ( HYMB).

For some investors, the discounts look tempting. After all, bargain hunters love to buy a dollar worth of assets for 99 cents. But analysts sound a note of caution. "When an ETF trades at a discount, it is not necessarily a buying opportunity," says Timothy Strauts, a senior fund analyst for Morningstar.

ETFs can slip to discounts for different reasons. To appreciate why emerging markets funds dipped last month, consider a hypothetical ETF that has $100,000 in emerging markets stocks and 10,000 shares. When markets in Asia and Africa closed on the day before the big downturn, each share in the ETF traded for $10 and was backed by that amount of assets. The fund did not trade at a discount. With the Asian stock exchanges shut for the day, share prices in much of the emerging markets could not change for 16 hours.

Meanwhile, markets opened in the U.S. After the Fed's unsettling news, investors worried that any trouble in the U.S. would also hurt emerging markets. Traders dumped shares of the hypothetical emerging markets ETF. While the ETF share price fell, the prices of many of the stocks in the portfolio could not budge because the Asian markets were shut. The ETF share price fell to $9 even though the value of the stocks in the fund remained at $10. As a result, the fund sold at a double-digit discount.

Despite the big discount, analysts say that the ETF is not really a bargain. When trading resumes overseas, the stocks are likely to fall down to the level of the ETF shares, and the discount will narrow. So investors who buy at discounts are not likely to book any windfall gains. "If you hold ETFs for long time horizons, it is irrelevant to you whether or not the securities swing to temporary discounts," says Paul Baiocchi, an analyst for IndexUniverse.com.

The discounts in bond funds occurred for reasons that were unique to the fixed-income markets. Consider a hypothetical ETF with $100,000 in municipal bonds. After Bernanke's statement, municipals tanked, and the fund slipped to a 5% discount. In this instance, it is hard to know whether the discount reflects the true value of the assets in the portfolio. The problem is that many municipal bonds rarely trade. The bonds are owned by retail investors and institutions who sock the securities away and never sell. Since there is no daily trading to provide real-time prices, ETF managers must estimate the value of the holdings in their portfolios. Say a fund holds a hospital bond that doesn't trade. The portfolio manager may estimate that the fair value of the bond is similar to an issue from the same industry that did trade. In real life, the price of ETF shares can drop faster than the estimates of fair values. That causes discounts.

The discounts of bond funds can be persistent during volatile periods. To appreciate why, consider an investor who wants to sell a single municipal bond. To complete the trade, the seller contacts his broker who plans to buy the bond from the client and then sell to someone else. Fearing that the prices could continue dropping, the broker offers a price that is below the current fair value. The client accepts the haircut because he needs to unload the security.

Bond ETF investors can experience similar trading difficulties. An investor who seeks to sell ETF shares may receive a low bid from an intermediary known as an authorized participant. The participant will buy the shares and give them to the ETF portfolio manager in exchange for actual bonds from the portfolio.

Should you sell a bond ETF during volatile periods when the shares trade at persistent discounts? Maybe not. Courageous buyers may want to step forward -- and hope to enjoy small gains by acting when others are selling.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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