Mutual Fund Pricing

[marko]

So another slow morning at the marko household.

Just musing: how do mutual funds get priced?

Is it some complicated formula that aggregates the prices of all the stocks within that fund?

Or is it simple supply and demand of the fund itself ?

Or something else?

 

[NW-Bound]

A mutual fund price is NAV (Net Asset Value). It is computed by adding up all the values of the fund assets minus all liabilities, then dividing this total by the number of outstanding shares of the MF.

The mutual fund computes this NAV at the end of each trading day, based on market values of its assets. You can only buy and redeem shares from the MF, and this is the price for the transaction.

In contrast with MFs, closed-end fund and ETF shares are traded between share owners. These shares may be traded at a higher or lower price than the NAV, which the trading parties may not even be aware of when making the trade. If the price is higher than the NAV, it is said to be trading at a premium. If the price is lower than the NAV, it is at a discount. These deviations are caused by demand or lack thereof of the shares being traded in the open market.

 

[MichaelB]

It’s the value of each holding using the price of the most recent market close. Some adjustment can be made if any of the holdings are traded in foreign exchanges, just to prevent investors from trying to arbitrage price differences.

 

[pb4uski]

NW-Bound nailed it.

 

[marko]

Thanks!

 

[audreyh1]

NW-Bound nailed it.

+1

 

[MRG]

A mutual fund price is NAV (Net Asset Value). It is computed by adding up all the values of the fund assets minus all liabilities, then dividing this total by the number of outstanding shares of the MF.

The mutual fund computes this NAV at the end of each trading day, based on market values of its assets. You can only buy and redeem shares from the MF, and this is the price for the transaction.

In contrast with MFs, closed-end fund and ETF shares are traded between share owners. These shares may be traded at a higher or lower price than the NAV, which the trading parties may not even be aware of when making the trade. If the price is higher than the NAV, it is said to be trading at a premium. If the price is lower than the NAV, it is at a discount. These deviations are caused by demand or lack thereof of the shares being traded in the open market.

+1
This is how it works. This process occurs between market close and 5PM.

Now how do ETFs ever get reconciled with their underlying assets?

 

[ERD50]

+1
This is how it works. This process occurs between market close and 5PM.

Now how do ETFs ever get reconciled with their underlying assets?

I'd assume that, at least with the large ETFs, that arbitrage and liquidity keeps them really close to par value (like within bid/ask/fees)? I don't know if there are any small ETFs.

For Closed End Funds we sometimes hear of them trading above/below par. Again, assumption on my part, but I think that is due to the cost of going in/out, and because they are priced at EOD, an arbitrager can't be certain they will get out at that same delta. And I'm always curious about someone touting a CEF as a bargain because it is trading below par. Well, why is it below par in the first place, and how can you know that will change? There must be a reason for it.

-ERD50

 

[youbet]

+1
This is how it works. This process occurs between market close and 5PM.

Is that 5PM figure a rule or a target? I own a fund (PIMIX) which doesn't price until after 5PM almost every day. And what happens when a MF owns a MF which owns a MF? It seems like there could be some cascading effect which takes time.

 

[MRG]

Is that 5PM figure a rule or a target? I own a fund (PIMIX) which doesn't price until after 5PM almost every day. And what happens when a MF owns a MF which owns a MF? It seems like there could be some cascading effect which takes time.

I think it's a target and I may have used central time. The folks doing the pricing and operations are trying to get it done ASAP as this is only the first process that needs to run after market close.

I'm not sure about funds of funds are priced. Could be the aggregate of the funds or they could, price it as it's own fund. Given processes exist to price the fund from underlying securities it makes little sense to reinvent, and test, that wheel.

 

[Turbo29]

How about bond mutual funds? Every bond in a fund may not trade daily yet if interest rates make a significant move the value of these bonds have also made a significant move. Using the last selling price for a given type of bond could be misleading.

 

[NW-Bound]

Now how do ETFs ever get reconciled with their underlying assets?

I'd assume that, at least with the large ETFs, that arbitrage and liquidity keeps them really close to par value (like within bid/ask/fees)? I don't know if there are any small ETFs.

For Closed End Funds we sometimes hear of them trading above/below par. Again, assumption on my part, but I think that is due to the cost of going in/out, and because they are priced at EOD, an arbitrager can't be certain they will get out at that same delta. And I'm always curious about someone touting a CEF as a bargain because it is trading below par. Well, why is it below par in the first place, and how can you know that will change? There must be a reason for it.

-ERD50

In order for arbitrage to work, there has to be a mechanism for it to happen. This mechanism exists with ETFs, but not with closed end funds. I will explain further, but first let's go back a bit in time.

The predecessors of ETFs are the "holders". HOLDRs (Holding Company Depository Receipts) were created in the late 90s by Merrill Lynch. I used to own shares of several HOLDRs in those days. HOLDRs were usually sectored funds, and traded only in round lots of 100 shares. And the constituents were also owned in whole shares and not fractional shares.

For example, a 100-share lot of a pharmaceutical HOLDR might consist of 10 shares of Merk, 12 shares of Johnson & Johnson, 8 shares of Pfizer, etc... An investor who owned this pharmaceutical HOLDR was also a direct owner of the contituent companies. Thus, I would receive company reports and have voting rights of all my shares in these companies. The above is not true with ETFs, nor with mutual funds.

The advantage of the HOLDRs is the same as with the current ETFs. You get diversification with a single purchase, while overweighing a sector that you think has a better prospect than the entire market. In return for the convenience, you pay a fee to the HOLDR manager, and this fee is deducted from the dividends paid by the constituent companies. This is not any different than with ETFs or MFs.

However, the bookkeeping of a HOLDR was more cumbersome and more costly, plus the requirement to trade in 100-share round lots kept out small investors. Thus, the HOLDRs were gradually phased out in favor of the ETFs.

In order to ensure that a HOLDR was valued at NAV (net asset value), the HOLDR manager permitted purchase and redeem of the HOLDR shares with in-kind trades. For example, if somehow a pharmaceutical HOLDR got traded at a discount, meaning at a lower price than the sum of its parts. Anybody could buy 100 shares of this HOLDR, then demanded the HOLDR manager to deliver the break-down, meaning delivery of the 10 shares of Merk, 12 shares of J&J, etc... He then sold the individual parts for more money, and pocketed the difference.

Conversely, suppose this pharmaceutical HOLDR got traded at a premium, meaning at a higher price than warranted by the sum of its parts. Anybody could gather up the 10 shares of Merk, 12 shares of J&J, etc..., then delivered this lot to the HOLDR manager in exchange of 100 HOLDR shares. He could then sell these 100 HOLDR shares on the open market at a higher price for a profit.

I don't know if this in-kind purchase and redeem transaction ever happened, but supposedly just the allowance of it means any mispricing would be detected by several investment houses, who would seize the chance to make money and drive the price difference back to zero. Thus, the HOLDR pricing is forced to follow the NAV price by deterrence.

The same mechanism exists with ETFs, by permitting in-kind trades to ensure price tracking via arbitrage.

However, no such arbitrage is possible with closed end funds. Hence, closed end funds often trade at a persistent discount to their NAV value. The discount is there, but how do you get money out of it? The only way you could to unlock the value is to take over the fund and close it down, then break it down into its parts and sell the individual pieces. This is how corporate raiders often take over a company and sell it in pieces.

Why don't closed end funds trade at a premium? I guess lack of popularity and liquidity of the closed end funds make them not in high demand.

 

[NW-Bound]

^^^ I imagine that the arbitraging of a HOLDR or ETF mispricing would be done via simultaneous purchasing the discounted side and shorting the expensive side.

This would immediately capture the price difference at that moment, and the profit is locked in, whether the stocks go up or down after the trades.

 

[OverThinkMuch]

ETFs have a list of institutional investors who are allowed to create and destroy ETF shares. There's also a defined minimum institutional amount, maybe 100k or 1 million shares.

An ETF might hold automakers (Tesla, Nissan, Ford), and lets say it goes too far above the NAV of those stocks. I don't know the exact order and derivatives involved, but somehow they have lots of ETF shares or some way to lock in the purchase price. They buy stock futures of Tesla, Nissan, Ford, etc. Now they execute the transaction to profit off the difference. They take a million shares of the ETF, and destroy them. They withdraw the stocks from inside those underlying shares, and deliver them per the futures contracts. Their profit is purchase price minus sale price, which is usually a very small fraction of a percent on a large transaction.

 

[GravitySucks]

How about bond mutual funds? Every bond in a fund may not trade daily yet if interest rates make a significant move the value of these bonds have also made a significant move. Using the last selling price for a given type of bond could be misleading.

Great question. Bond markets aren't as transparent.
Something new for me to worry about on the fixed income side. I always assumed the FI side would be easy to manage. I hardly had any while working and these days I find them more confusing than stocks or stock MFs

 

[SecondCor521]

^^^ I imagine that the arbitraging of a HOLDR or ETF mispricing would be done via simultaneous purchasing the discounted side and shorting the expensive side.

This would immediately capture the price difference at that moment, and the profit is locked in, whether the stocks go up or down after the trades.

I know one can buy and sell options on stocks, but I am not sure (because I know little to nothing about options) if one can buy and sell options on ETFs.

The above strategy would seem to rely on the ability to short an EFT. I wonder if that is actually possible?

(One could, in theory, short every holding in the ETF proportionally, but that seems like a lot of work and cost to make this arbitrage play work.)

 

[MRG]

How about bond mutual funds? Every bond in a fund may not trade daily yet if interest rates make a significant move the value of these bonds have also made a significant move. Using the last selling price for a given type of bond could be misleading.

Well they need a price. The person who wrote the code either A. used the last available price or B. went through some algorithm to predict what the price should be. I'd go with A as B sounds like a great way to start going down a slippery slope.

 

[NW-Bound]

I know one can buy and sell options on stocks, but I am not sure (because I know little to nothing about options) if one can buy and sell options on ETFs.

Yes, you can buy/sell put/call options on most, if not all, of the ETFs.

I don't know if there are ETFs that have no options on them, but it is possible. It's because I know that there are plenty of stocks that have no options. These are mostly thinly traded stocks that do not have a large group of followers.

Options need to have a market maker. See: https://en.wikipedia.org/wiki/Market_maker.

The above strategy would seem to rely on the ability to short an EFT. I wonder if that is actually possible?

Yes, you can short an ETF just like a stock. And you may not be able to short it if your broker runs out of shares to let you borrow to sell, just like what can happen with a stock.

One could, in theory, short every holding in the ETF proportionally, but that seems like a lot of work and cost to make this arbitrage play work.

True. It would not be something done by an individual investor. I imagine investment bankers like Goldman Sachs would have their computer spot a mispricing in a fraction of a second, and immediately pounce on the chance if the gain is worth the transaction cost.

And I suspect that they don't even need to short anything, as they probably have shares of everything tradable out there in their inventory.

 

[NW-Bound]

ETFs have a list of institutional investors who are allowed to create and destroy ETF shares. There's also a defined minimum institutional amount, maybe 100k or 1 million shares.

An ETF might hold automakers (Tesla, Nissan, Ford), and lets say it goes too far above the NAV of those stocks. I don't know the exact order and derivatives involved, but somehow they have lots of ETF shares or some way to lock in the purchase price. They buy stock futures of Tesla, Nissan, Ford, etc. Now they execute the transaction to profit off the difference. They take a million shares of the ETF, and destroy them. They withdraw the stocks from inside those underlying shares, and deliver them per the futures contracts. Their profit is purchase price minus sale price, which is usually a very small fraction of a percent on a large transaction.

Yes, I imagine it would be something like the above.

 

[SecondAttempt]

I'd assume that, at least with the large ETFs, that arbitrage and liquidity keeps them really close to par value (like within bid/ask/fees)? I don't know if there are any small ETFs.

For Closed End Funds we sometimes hear of them trading above/below par. Again, assumption on my part, but I think that is due to the cost of going in/out, and because they are priced at EOD, an arbitrager can't be certain they will get out at that same delta. And I'm always curious about someone touting a CEF as a bargain because it is trading below par. Well, why is it below par in the first place, and how can you know that will change? There must be a reason for it.

-ERD50

My understanding as well. T. Rowe Price recently announced ETFs that do not disclose their holdings to protect their trading startegies. I am not on board with this so have not bought any but I wonder how this factors into the valuation of mutual funds. I'm sure TRP is not a trendsetter in this area!

 

[Montecfo]

A mutual fund price is NAV (Net Asset Value). It is computed by adding up all the values of the fund assets minus all liabilities, then dividing this total by the number of outstanding shares of the MF.

The mutual fund computes this NAV at the end of each trading day, based on market values of its assets. You can only buy and redeem shares from the MF, and this is the price for the transaction.

In contrast with MFs, closed-end fund and ETF shares are traded between share owners. These shares may be traded at a higher or lower price than the NAV, which the trading parties may not even be aware of when making the trade. If the price is higher than the NAV, it is said to be trading at a premium. If the price is lower than the NAV, it is at a discount. These deviations are caused by demand or lack thereof of the shares being traded in the open market.

Just to clarify, open-end and closed-end funds are both types of "mutual funds". They trade differently as noted, with open-end funds trading at NAV only at closing price, and closed-end funds trading throughout the day at whatever price the market will bear.