ETFs and Mutual Fund Accounting

We’ve discussed active ETFs and the transparency issue in previous blogs (part 1, part 2 and part 3). An interesting corollary issue that inevitably pops up in these discussions runs something like this, “But if the manager of an active ETF can change the composition of the portfolio at any time during the day, how will market makers be able to keep track of the changes and maintain effective trading?” A perfectly reasonable question, but the answer may seem counterintuitive. They don’t have to. At least, not in any case we’ve run across so far. But how is that possible?

Remember, there is an arbitrage mechanism which provides for Authorized Participants (APs) to transact with the fund directly at the end of the day at NAV through the creation/redemption process. This mechanism provides the means by which the market price will be forced to converge to the underlying value of the fund (NAV) each day.  Given that, surely any market maker would need to know the current holdings of the fund during the day, even if they change, in order to quote effective prices, right? Wrong. Let me explain.

The key to understanding this seeming incongruity lies in the definition for Net Asset Value (NAV) contained in Rule 2a-4 of the Investment Company Act of 1940 (the “40 Act”).  Here it is:

Rule 2a-4 -- Definition of "Current Net Asset Value" for Use in Computing Periodically the Current Price of Redeemable Security

  1. The current net asset value of any redeemable security issued by a registered investment company used in computing periodically the current price for the purpose of distribution, redemption, and repurchase means an amount which reflects calculations, whether or not recorded in the books of account, made substantially in accordance with the following, with estimates used where necessary or appropriate.
    1. Portfolio securities with respect to which market quotations are readily available shall be valued at current market value, and other securities and assets shall be valued at fair value as determined in good faith by the board of directors of the registered company;
    2. Changes in holdings of portfolio securities shall be reflected no later than in the first calculation on the first business day following the trade date;
    3. Changes in the number of outstanding shares of the registered company resulting from distributions, redemptions, and repurchases shall be reflected no later than in the first calculation on the first business day following such change;
    4. Expenses, including any investment advisory fees, shall be included to date of calculation. Appropriate provision shall be made for Federal income taxes if required. Investment companies which retain realized capital gains designated as a distribution to shareholders shall comply with paragraph (h) of Rule 6-03 of Regulation S-X;
    5. Dividends receivable shall be included to date of calculation either at ex-dividend dates or record dates, as appropriate;
    6. Interest income and other income shall be included to date of calculation.

(This language can also be viewed here)

Section (a)(1) specifies that prices used to value securities in order to determine NAV should be current.  No surprise there.  But Section (a)(2) says any changes in holdings can be reflected the day after they occur.  So, while the NAV on any given day T must be calculated using prices as of T (as long as prices are available), the holdings are allowed to be the holdings as of T-1. And, in every case we are aware of, this is how funds actually calculate their NAV, including those funds underlying ETFs.

What this means is that given typical industry practice a market maker need not be concerned with changes in the holdings of the underlying fund during the day since the NAV at the end of the day will be calculated using the holdings from the previous day. From the point of view of the market maker and the arbitrage mechanism, the relevant holdings are those from T-1 and remain static throughout the day, regardless of any changes made by the manager during the day.

If a fund underlying an ETF were to move to “T accounting” for holdings (which is permitted under the rule), wherein the NAV would reflect any changes in holdings made during the day, then the market makers would indeed need to know about those changes during the trading day. As you might suspect, this would make the information disclosure needs much more challenging for any ETF making changes during the day, regardless of which information disclosure process one might use, including full daily disclosure. Not impossible, just more challenging.