how one China-related ETF has fared

Yesterday I mentioned a Factset article about the trading behavior of China-related ETFs during the current market gyrations in Shanghai and Shenzhen.  It focuses on the Deutsche X-trackers Harvest CSI 500 China-A Shares Small Cap ETF (ASHS).  Quite a mouthful.

ASHS opened for business last year and has about $41 million in assets.  Its goal is to track the performance of 500 Chinese small caps.  It holds all of the names in the appropriate proportions, to the extent that it can.  Where it can’t, it finds the best proxies available.

Year to date through yesterday, ASHS has risen by 37%+.

The fund melted up in mid-June, however.  Its price rose by 40% from June 8th through June 10th alone, at which time it had y-t-d performance of +113%.

The bottom fell out in the following month, when ASHS lost slightly more than half its value–before bouncing back up by +30% over the past few weeks.

Two points about ASHS:

1.  The fund uses fair value pricing, which is the industry norm in the US.  Fair value pricing, usually performed by a third party the fund hires, does two things:

—-it adjusts the prices of foreign securities in markets that are closed during New York trading for information that has come to light after their last trade, and

—-it gives an estimate for the value of securities that are not trading for one reason or another on a given day.

(Note: in my experience, both types of adjustment are surprisingly reliable.)

This second feature has doubtless come in handy over the past couple of months, since there have been days when as many as half of the Chinese small caps haven’t traded.


2.  A mutual fund transacts once a day, through the management company, after the market close and at Net Asset Value.

In contrast, an ETF like ASHS trades continuously during the day, through a number of broker dealers (Authorized Participants), and not necessarily at NAV.

The idea is that these middlemen will use the very cheap brokerage record systems for fund transactions, thus keeping administrative costs down–and that the brokers will use their market making and inventory capability as a way of minimizing the daily flows in and out of the ETF portfolio.

In June, this worked out in an interesting, and ultimately stabilizing way for ASHS.

As I mentioned above, the market price of ASHS rose by 40% over two days in mid-June.  We know that, according to Chinese trading rules, the stocks in the portfolio itself could rise in value by at most 10% daily, or 21% over two days.  I can’t imagine the ASHS fair value pricing service decided that the portfolio was actually worth 40% more than two days earlier when the market signal was twenty-ish.  If I’m correct, the broker dealers decided to meet (presumably large) demand for ASHS shares by letting the premium to NAV expand substantially  …by 20%?…thereby choking some of the demand off, rather than issue a ton of new ASHS shares at a lower price.

According to Factset, the brokers did create new shares.  But they apparently lent at least some of them to short sellers, who sold them in the market, further tamping down demand.

So the Authorized Participants performed their market-making function admirably–presumably making a boatload of money in the process.   But this situation illustrates that the worst fears of possible ETF illiquidity in crisis times may be overblown.






Morgan Keegan, fund directors and fair value pricing: and SEC action to keep tabs on

Morgan Keegan, now a part of Raymond James, was a regional brokerage firm with a strong fixed income emphasis.  It was severely wounded by large losses in fixed income mutual funds during the housing meltdown, and by subsequent SEC legal actions.  The regulator accused the firm of misrepresenting the risk character of some mutual fund offerings to potential clients and of systematically mispricing funds over extended periods of time.  As part of a settlement, the portfolio manager who ran a number of these funds agreed to a fine of $500,000 and a lifetime ban from the securities industry.

“So, what’s new?” you may ask.

What’s unusual about this case is that late last year the SEC sued the boards of directors of some of these funds for what it says was their failure to ensure that the funds were priced correctly.   Although directors are, legally speaking, the highest-ranking officials in any mutual fund and are therefore directly responsible for the conduct of the fund’s officers and staff, the SEC has until now only held the investment professionals and support staffs of wayward funds accountable for their actions–and left the directors alone.

my thoughts

1.  The returns cited by the Wall Street Journal  for one of these funds in reporting on this case are really ugly.  It lost 30% of its value in 2008 vs. a return of +6.8% by the fund’s performance benchmark.  In 2008, the fund was down by 73.2% vs. a benchmark return of +4.0%.

2.  Fair value pricing–meaning having third-party experts estimate a price for a security if there are no trades for it on a given day–is an important issue.  Typically a rogue manager or a rogue firm will want to assign securities a price that’s too high, to disguise a fund’s underperformance.

The problem:  shareholders who sense the problem early and cash in their shares get more than their share of the fund assets, leaving loyal/trusting shareholders with a large hole in their fund NAV once the fraud is uncovered.

3.  Fair value pricing isn’t a new issue.  It was a big problem during the collapse of the junk bond market in the late 1980s.  It was also the centerpiece of Eliot Spitzer’s expose of shady practices by international funds in the mid-1990s.  Apparently the SEC again called mutual fund boards’ attention to possible fair value pricing issues with funds holding mortgage-backed bonds in 2007.

4.  The SEC must think that its warnings were being ignored by mutual fund boards and that it had to make an example of someone.

5.  If so, the agency appears to have chosen its target well.  Morgan Keegan isn’t a large, deep-pocketed, politically powerful investment banker like Goldman Sachs or Morgan Stanley.  The Morgan Keegan name no longer exists.  The firm has recently been sold to Raymond James, whose executives presumably have no personal ties with the accused directors and no interest in prolonged or expensive litigation which would only keep any past Morgan Keegan misdeeds in the public eye.

Yes, the directors doubtless have liability insurance against possible lawsuit.  But my guess is that the insurer in question may assert that coverage doesn’t extend to instances like this.

This case has the potential to change the way mutual fund directors are selected, what qualifications they should have, how they carry out their duties and how much they’re paid.  It’s worth keeping an eye on.

What is fair value pricing?

what it is:  two meanings

The overall idea is to price a mutual fund or an ETF using up-to-date prices.  The two meanings:

1.  The less important:  Mutual funds and ETFs price their holding every day.  If the fund owns a security that hasn’t traded on a given day–maybe it’s highly illiquid, or maybe it’s suspended an hour before the close pending an important announcement–a committee meets to determine, as best it can, what the proper closing price should be.  That’s one kind of fair value pricing.

2.  The more important:  The US stock market is open from 9:30 am until 4:00 pm, Eastern time.  Europe is open from around 4:00am until noon Eastern.  The Pacific opens at around 6:00 pm and closes around 2:00 am Eastern.

International or global mutual funds and ETFs are priced at the New York close at 4:00 pm Eastern time.  But the closing price for the securities it holds may have been at 2 am or at noon Eastern.  A lot of stuff that’s important to a stock’s price may happen between closing in the local market and the New York close, however.

The same is true of the currency of the local country, which probably trades twenty-four hours a day, around the world.

For many years, mutual funds used the local market close and possibly the local market currency value in calculating the daily net asset value of the fund, the figure at which shares are bought and sold through orders placed up until 4pm Eastern that day.

In other words, you could buy stocks at 4 pm whose prices were set at 2 am, without adjustment for any information that might have entered the market in the intervening time.

What kind of information?  …earnings reports from European or American firms, government economic announcements, or the rise or fall of western hemisphere stock, bond or currency markets.

This practice gave rise to a kind of time-zone arbitrage, that was most pronounced in the case of a US-based Pacific Basin fund.  Let’s say the US market was up 2% at 3 pm on a given day.  Chances are high, just on that basis, that Pacific markets would be up significantly that night as well.  But you could still buy shares of the fund at last night’s prices. On the other hand, if the European and American markets tanked, you could sell the Pacific funds you held at yesterday’s higher prices.

But market levels aren’t the only information you’d have access to.  You could see trading of Pacific securities in London and in New York.  You could see currency and interest rate movements.  And you could see the Nikkei futures (Japan) traded in Chicago.  So you could create a relatively sophisticated set of buy/sell signals, all predicated on the idea that you could in effect transact at yesterday’s prices.

As interest in foreign markets rose, and as more people worked out that this arbitrage could be highly profitable, mutual fund organizations began to experience significant numbers of shares being aggressively traded in and out of their foreign-oriented fund.  This created a severe technical problem for a portfolio manager in remaining fully invested, while at the same time raising and investing cash to match the individuals and organizations doing this time zone arbitrage.  More important, the trading activity was highly lucrative, meaning that to some degree these profits were being earned at the expense of the large majority of fund shareholders who were not constantly trading the fund shares, and who were likely unaware that this kind of activity was going on.

No-load funds had this problem before their load brethren.  No-loads pioneered the solution.  They hired third parties–S&P and the Financial Times are two of them–that had developed predictive software that determined what the New York closing price of any foreign security should be if the local market had access to financial information that emerged between the local close and 4pm New York time.  They also developed decisions rules that determined when to use local closing prices and when to use those generated by the third-party.  A typical rule would be that if the S&P 500 closed with up or down .5% vs. the previous close, the third-party implied quotes would be used.

Using fair value pricing has been the norm for US-based funds for years.  True, some fund groups required a nudge from the Attorney General of New York or of Massachusetts before falling in line.  But the “shooting fish in a barrel” arbitrage has been eliminated.

My firm used the FT figures.  In volatile markets, they would be used quite frequently instead of the local close figures.  Although I’ll admit to being skeptical at first, I was pleasantly surprised–maybe shocked is a better word–at how accurately the FT numbers mirrored the opening trade for the securities that night.

why is this important?

I own shares in an international mutual fund in an IRA.  I’ve been gradually selling my position down and replacing it with individual stocks.  I surprised myself on Monday–the US was down sharply when Europe closed but recovered to end just below breakeven at 4pm–by thinking for a minute that I shouldn’t sell shares that day but should wait to see if the better US close caused a sympathetic rebound in Europe on Tuesday.  Then I realized that the potential rebound is already priced in, thanks to fair value pricing.  One more thing neither you nor I have to worry about.