EXCHANGE-TRADED FUNDS – Illiquid Security Valuation
Exchange-Traded Funds (ETFs) are investment funds that combine the features of a mutual fund and a closed-end fund. ETFs trade throughout the day at prices that may be above or below the fund’s net asset value. Shareholders may trade shares of the ETF resulting in capital gains or losses. Additionally, shareholders are entitled to a share of the fund’s profits from interest or dividends.
Unlike mutual funds, ETF’s do not redeem individual shares at net asset value. Large financial institutions will typically purchase large blocks, called Creation Units, of the ETF by delivering a basket of securities of the same type and proportion as the ETF. Once settled, the institutions are free to hold their investment in the ETF or sell their shares on the open market. This balancing mechanism provides liquidity to the marketplace and the opportunity for profit through arbitrage.
Current Market: There are currently over 1,500 ETFs traded in the U.S. totaling over $2.5 trillion in assets. Since their inception in 1989, ETFs have evolved from index tracking funds into targeted investment vehicles. ETFs can target a certain sector, geographical region, commodity, or other asset class. While most ETF’s mimic a 1x price move in the underlying basket of securities, some ETFs are structured with derivatives in order to leverage their investment up to 3x the underlying basket of securities. Other ETFs are structured to mimic an inverse relationship with the underlying basket. Along with traditional ETFs, inverse and leveraged ETFs provide countless ways in which an ordinary investor can diversify his or her portfolio. Further, ETFs operate at a significantly lower expense ratio than traditional mutual funds. Most ETFs have an expense ratio ranging from 0.1% to 1.0%, while mutual funds charge a higher fee ranging from 1% to 3%.
Reporting Requirements: The Securities and Exchange Commission (SEC) requires most ETFs to disclose their holdings on a daily basis. This is normally not an issue if the closing prices of the ETF and the underlying securities are readily available through a liquid market. However, there are times, for various reasons, when an underlying security becomes halted or suspended from regular trading. This may cause issues in determining and supporting the ETF’s daily net asset value.
Houlihan Capital has extensive experience in valuing illiquid securities and in providing valuation consulting services. These services assess the soundness of the fair value methodology for illiquid securities within an ETF in order to validate such valuations are appropriate for reporting purposes.
For more information regarding our valuation and financial advisory services, please contact Jules Pomerantz at 312.450.8607 or jpomerantz@houlihancapital.com.
