Understanding Premiums And Discounts

Confusing as it seems, ETFs have more than one "price."

First, there’s its actual value, which is measured by net asset value (NAV) at the end of each day and by intraday NAV (iNAV) in the middle of the day.

However, because ETFs trade on an exchange, they also have a current market price—which could be more or less than its actual value.

In short, if the price of the ETF is trading above its NAV, the ETF is said to be trading at a “premium.” Conversely, if the price of the ETF is trading below its NAV, the ETF is said to be trading at a “discount.”

In relatively calm markets, ETF prices and NAV are generally close. However, when financial markets become more volatile, ETFs quickly reflect changes in market sentiment, while NAV may take longer to adjust—resulting in premiums and discounts.

Why?

This can happen throughout the trading day, because the ETF and its underlying securities are actually two distinct liquidity pools that are only loosely linked.

If optimistic investors start aggressively bidding up an ETF—more so than its underlying securities—the price of the ETF may rise faster than the price of its underlying securities and, consequently, may trade at a premium.

Similarly, if pessimistic investors aggressively sell an ETF—more so than its underlying securities—the ETF may trade at a discount. Imagine a sumo wrestler escaping through a small window.

Alternatively, premiums or discounts may arise because the ETF and its underlying securities trade on exchanges that are in different time zones.

Consider the scenario of ETFs listed on the NYSE that track the FTSE 100. It’s not uncommon for those ETFs to trade significant volume after the London Stock Exchange closes at 11:30 a.m. ET. The price of these ETFs will reflect real-time changes in market sentiment, while NAV will be based on stale prices from the earlier LSE close.

In this case, any significant deviation between ETF price and NAV will likely vanish when both exchanges are open at the same time.

How Are Premiums And Discounts Corrected?

Thanks to the creation/redemption mechanism, deviations between ETP price and its NAV tend to be short-lived. (See our article, “What Is The Creation/Redemption Mechanism?” for more.)

That said, not all premiums and discounts quickly self-correct; some persist for a variety of reasons. For an authorized participant (AP) to create or redeem shares quickly, he or she needs access to the underlying securities—which is not always possible. (See "Understanding Premiums And Discounts.")

Sometimes access is just a time challenge: For ETFs holding international securities, there could be a delay before the AP is finally able to access the underlying market and effectively create or redeem ETP shares—the delay can lead to temporary premiums and discounts.

Other times, restricted access to the underlying securities could be symptomatic of more serious structural problems. Depending on the severity, the issuer may even have to halt the creation of new ETF shares.

During the Arab Spring, for instance, ETFs tracking the Egyptian markets shuttered, leading to wild swings in the perceived premiums of those ETFs. In these cases, the ETF effectively starts trading like a closed-end fund, and can trade at constant premiums until creations are resumed, when such premiums usually vanish.

The important thing to remember is that ETFs generally trade close to their fair value, and premiums or discounts tend to be short-lived. However, that’s not always the case, so dig deeper before snapping up a fund simply because it’s trading at a discount (you may have to sell at a bigger discount). Lastly, use limit orders set close to NAV to prevent buying at a large premium or selling at a large discount.

Next: Understanding iNAV

Other Articles Of Interest

Understanding Premiums And Discounts
What Is The Creation/Redemption Mechanism?