ETF Talk: Clearing Up the Mystery of Mispriced Funds

As much as I like exchange-traded funds (ETFs), I frown when they become mispriced. This happens when the market price of an index ETF is different from its underlying net asset value (NAV). If an investor in such an index ETF needs to sell quickly, the mispricing may cause a bit of a financial hit.

In reality, the price of an index ETF "resembles," but is independent of a fund’s NAV. For example, when there suddenly are more fund sellers than buyers, the market price of an index ETF may be lower than its NAV. With the recent market drops giving nervous investors a host of reasons to sell, the risk of such mispricing is heightened. I want you to be aware of this mispricing risk if you are thinking about buying index ETFs. If your plan is to buy and to sell quickly as a short-term trader, you face an increased risk of mispricing.

On the other hand, it also is possible for the market price of an index ETF to exceed its NAV when demand for fund shares temporarily exceeds the supply. This situation is not a problem for ETF sellers, as long as the buyers are willing to pay a premium to acquire the shares.

You also should be aware that "tracking errors" can occur. That situation can happen when an ETF pays out quarterly dividends that are received from the underlying stocks that it holds. However, the stocks held by the ETF may pay dividends to the fund throughout the quarter. As a result, an ETF may hold the cash received from the dividend payments, even though the underlying benchmark index does not hold any cash. This situation particularly applies to index ETFs known as HOLDRs that are organized as trusts. The HOLDRs cannot reinvest dividends, and must hold any dividend payments as cash.

Even though I am a big fan of ETFs, I want to be sure that you to know about the mispricing and tracking error issues that I just highlighted. Every investment has its strengths and weaknesses, so it is in your best interest to know the facts before investing your hard-earned money in anything.

In closing, I want to encourage you to ask me any questions that you may have about ETFs. If you have ETF-related questions, please click here.

Finally, you should not avoid investing in index ETFs just because of mispricing and tracking errors. However, I want you to be fully informed about these imperfections. Remember that I’m here to help guide you and it gives me great satisfaction to illuminate the path for investors who seek to invest in ETFs successfully.