ETF providers take issue with market open pricing

The exchange-traded fund industry is concerned about the Toronto Stock Exchange’s Market On Open system, which can have ETF prices open at prices substantially higher than their underlying net asset value (NAV).

Normally, the net asset value of ETFs closely tracks the underlying value of their constituent securities. The difference in price is referred to as a tracking error; it’s usually very small. As ETF usage has exploded during the market downturn, there have been cases in which market open price of certain ETFs have been out of whack with the market value.

Market On Open orders are those orders filed before the TSX opens at 9:30 a.m. The investor doesn’t know the exact price and will be sold the securities based on a number determined by the existing bid/ask quotes placed in the system.

If prices open higher than the NAV, an immediate loss is created for buyers since it will take only a few minutes into trading to bring the ETF market price in line with its NAV.

On October 14, there were some large discrepancies in market open price and the NAV of ETFs. This had ETF providers calling for market reform, and one investment counsel seeking the intervention of provincial regulators.

Som Seif, the president of Claymore Investments, explains that the market open ask price is determined by the TSX’s Quantum trading engine, which culls an average opening price based on the number of lots and quotes entered by brokers.

“Designated brokers are waiting for the underlying stocks to open up. When Royal Bank or Manulife Financial opens, their stocks might open up 1% up or 2% down. Twenty seconds after 9:30 a.m., you know what Royal Bank or Manulife are going to start trading at. (ETFs also open at 9:30 a.m.), so things will always be a bit wider first thing in the morning, because the market doesn’t know what the NAV is,” he says.

Generally, the designated brokers who hold contracts with ETF providers to create the market for ETFs that day are able to create a price that reflects the underlying basket of securities. Seif believes an unprecedented amount of last-minute ETF market open orders meant overwhelmed designated brokers were unable to create the appropriate prices in time for market open.

“(Canadian) designated brokers are dealing with 70 ETFs across the board,” he says. “There was an unbelievable amount of trading pressure and demand as market orders came in. The day before, the U.S. market had a huge run-up, and all these people put in their orders at around 9:30 a.m., and the designated broker couldn’t keep up with this.”

The result was a huge mispricing for anyone who had open market bid orders for ETFs. One of these investors was Hahn Investment Stewards, which has filed an application with the Ontario Securities Commission to overturn an Investment Industry Regulatory Organization of Canada’s decision not to re-price the market open prices of ETFs that morning.

In its application, Hahn notes that some of the ETFs, like XIN, an ETF that tracks the MSCI EAFE index, opened 63.93% higher than the previous day’s closing price, while the actual MSCI EAFE index opened up at only 7.93%. Hahn estimates its clients paid $1.45 million above market value for various ETFs listed that day.

According to the application, the big issue is not so much that this happened but that the TSX recognized the mispricing since it halted trading on most of the ETFs within 10 minutes of opening but did not repeal the opening prices for that day.

“The TSX can usually re-price — and should re-price — in the event something like this happens,” Seif says. “First of all, they sat on it. They also have to go to the Investment Industry Regulatory Organization of Canada to get re-pricing approval, and when the TSX did, IIROC declined it and wouldn’t re-price. That was unacceptable.”

Seif says his company and other major ETF providers in Canada are now lobbying the TSX to change its market opening price system.

“This is not an ETF player issue. This is the market. We’ve been complaining for a long time about the market on open and market on close mechanisms that don’t allow designated brokers to effectively handle order flows properly,” he says.

ETF providers are pushing for the TSX to create a trigger that will halt trading of ETFs that are exhibiting a wide margin of mispricing.

“This would allow the designated brokers to get in there and fix the price up,” he says. “They halted all the stocks for about five minutes because they saw what happened. The TSX should have actually halted those at open. They should have seen that the open was going to be about 25% greater than the market was and decided it was unacceptable and stopped this.”

(12/23/08)