Innovating for the ETF industry
We are at it again! A relentless pursuit of trying to make markets better for investors, issuers, and dealers alike.
There’s currently a public comment process underway for our latest innovation – and we want your comments – so please make sure to read to the very end. Before we get to that, though, we need to take a step back and look at some of the issues the ETF industry is facing. Fragmentation of trading in ETFs is a reality and so is the fact that many products don’t trade frequently. In fact, most ETFs trade very infrequently as you can see below.
Why does this matter? First of all, and this is a topic we have been harping on for a long time, Canadian retail investors and their advisors do not have access to consolidated data. As a result, they missed out on 66% of the trading activity, on average, in TSX-listed ETFs in Q3 2020. If you compound fragmentation with infrequently traded ETFs, you will have scenarios where they see nothing. That one ETF strategy of interest may have most recently traded last week, and when it did, it may have occurred on a market other than the listing exchange. Reflect on that for a moment.
There’s a holistic solution to this problem: mandated Canadian real-time consolidated market data, like in the US. Read more about it here. But this will not happen without regulatory intervention. We are, however, encouraged to see this is now an area of focus for the regulators, so perhaps there’s light at the end of the tunnel after all. In the meantime, investors in ETFs listed on NEO get to benefit from less fragmentation and free real-time market data (including full depth of book).
The second reason why it’s important to note that ETFs trade infrequently relates to the official closing price of an ETF. That price is used by investors to value ETF holdings in a portfolio, amongst other things. The closer that price is to the official NAV of the ETF, the better, as any discrepancies between the two will lead to unwarranted tracking errors.
The TSX’s definition of the closing price – applicable to ETFs listed on the TSX only – is simply the last price the ETF traded at, on the TSX. That is acceptable for an ETF that trades thousands of times a day (there are a few of those as you can see above). However, when the last trade happened weeks ago, things get completely out of whack! Remember, ETFs are just baskets of other securities so while the ETF itself may not have traded, the value of the underlying securities will have changed, and as a result, so has the NAV.
We used to have that definition at NEO, too, but we changed it a couple of years ago as it simply didn’t make sense. It doesn’t acknowledge fragmentation (we are not the only marketplace in town) and it doesn’t acknowledge the fact that some ETFs just don’t trade a lot (by design, as most are investment vehicles). To address this challenge, we now look at the bid/ask quotes during the last 15 minutes and calculate a time-weighted average midpoint price, which becomes the official closing price if there are no trades during that period. Oh, and I should mention that we do this based on consolidated data, recognizing the importance of other marketplaces for price discovery.
Here’s some data to illustrate this, where we compare our old methodology (which TSX still uses) with our current methodology, expressed as the deviation from the official NAV. As you can see, our current methodology is a superior approximation of the NAV. The benefit? More accurate valuation for investors holding those ETFs.
Which brings us to our latest innovation, for which we have a patent pending. The problem of using a derived value as the closing price is that it doesn’t get propagated to all downstream systems in the same way that a trade from a closing auction does. Well, we came up with a solution for that too. A solution that is extremely impactful, while at the same time, simplistic in nature so that it is easy to pick up for vendors – an end of day closing price publication via a zero-volume trade. Our proposal is currently subject to a public comment process and we encourage everyone to participate.
To conclude, listing ETFs on NEO is just the right thing to do.
Chief Operating Officer, NEO