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Auction rate muni's didn't work as planned. What assures that the market price of ETF's be trade near net asset value?

Aug 25, 2013 by Barry from St. Louis, MO in  |  Flag
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David P. White Level 9

Exchange Traded Fund (“ETF”) share market prices should never deviate significantly from NAV per share. Reason being, each ETF share is fully-collateralized by an underlying basket of securities. A closer look into how an ETF share is formed will better illustrate my point.

When an ETF issuer wants to create new shares of its fund, whether to launch a new product or meet increasing market demand, it turns to an authorized participant (“AP”). An AP may be a market maker, a specialist or any other large financial institution. But essentially, it's someone with a lot of buying power. The creation/redemption process is important for ETFs in a number of ways. For one, it’s what keeps ETF share prices trading in line with the fund’s NAV.

Because an ETF trades like a stock, its price will fluctuate during the trading day, due to simple supply and demand. Should an ETF become more expensive than the sum of its underlying securities, an AP can buy up the underlying shares, form a creation unit and exchange it, and sell the ETF shares on the market. This process brings the ETF’s price back to its NAV. Likewise, if the underlying securities become more expensive, then the AP can purchase a creation unit's worth of ETF shares and redeem them for their underlying securities, which can then be resold. This is called arbitrage, and it helps to keep an ETF's price in line with the value of its underlying portfolio. Over time, these buying and selling pressures balance out, and the ETF's market price typically stays in line with the value of its underlying securities.

Auction Rate Muni’s morphed out of a security termed an Auction Rate Preferred Stock that was typically issued as a second, albeit “senior”, class of securities of a closed-end municipal bond fund. Auction Rate Preferred Stocks were generally rated AAA because they had significant (sometimes up to 500% coverage) collateral securing the terms of the offering.

These securities had strong demand that outstripped supply, so Municipal issuers decided to capitalize by issuing Auction Rate Munis with similar terms as the Auction Rate Preferreds directly to the public. The main difference was the liquidity provision. Instead of having significant collateral to assure that the investor receives their principal and interest back upon demand, that feature was secured only as a moral obligation of the issuing Municipality. When redemption requests skyrocketed in 2008, many municipalities defaulted on their obligation to redeem securities at 100% of principal value.

Wall Street has settled many complaints related to the marketing of Action Rate Munis. Unfortunately, these securities were conveyed by unwitting financial professionals to have the same attractive features as their AAA predecessors. However, in the end, their junior credit status made them a much inferior security. That’s why it is important to seek the counsel of a seasoned professional that can understand and communicate associated risks and benefits to their clients.

Comment   |  Flag   |  Sep 04, 2013 from San Diego, CA

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One of the advantages of ETFs is that traders can buy and sell these instruments throughout the day. Most mutual funds on the other hand are bought and sold at the funds NAV - determined after the close of the trading day. Due to supply/demand dynamics, ETFs may trade at either a premium or discount to the underlying assets. In volatile market conditions, this premium/discount may widen.

Comment   |  Flag   |  Aug 29, 2013 from Cranford, NJ

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As with most investments there is no guarantee. While most ETFs are designed to trade near their underlying value, prices can and will vary. Increased market volatility increases the likelihood that the ETF's price will vary from the net asset value.

Comment   |  Flag   |  Aug 27, 2013 from Alexandria, VA

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The only thing I would add, is when you purchasing an ETF the most important aspect to look at is Volume. That dictates your Bid and Ask Spread. You want to purchase ETF's that have the smallest spread. That is why when you see some companies advertise free ETFs to trade, there is no commission to pay however the you loose significantly more on the spread of many of those ETF's. Best of Luck Sincerely Michael

Comment   |  Flag   |  Nov 05, 2013 from Farmington, CT

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