Confusing World Of ETF Premiums & Discounts

November 19, 2018

NAV Synchronization

In addition to foreign equity funds, ETFs that hold fixed income, futures, physical precious metals or cash in a non-native currency strike their NAVs at some time prior to the U.S. equity market close. While the ETF will trade at real-time valuations during the whole trading day, its NAV will not update.

The result is what you see in the EFA chart above, which show an apples-to-oranges comparison. The last price is updated through 4 p.m., while NAV is frozen at 10 a.m. (non-U.S. equities, precious metals, and currencies), 2:30 p.m. (futures) or 3:00 p.m. (bonds).

Bond Funds’ Tragic Timing Mismatch

U.S. Treasury bonds can be subject to spurious premium/discount results, because the U.S. Treasury market’s official close is 3 p.m. ET. That’s when many fixed-income issuers calculate NAVs.

The scatter plot below shows the distribution of premium/discount values for the iShares 20+ Year Treasury Bond ETF (TLT). While the average premium is close to 0.00%, the range is significant. This happens because after-hours moves in the price of long-dated Treasury bonds can be significant if interest rate expectations shift between 3:00 and 4:00 p.m. ET.



Precious Metals Officially Priced In London

The same thing happens with precious metals such as gold. While gold trades around-the-clock, GLD’s NAV is set using the 4 p.m. GMT price of gold. GLD’s NAV’s early strike time is out of synch with the U.S. market close, producing an end-of-day chart that suggests that customers cannot count on fair execution in GLD.



Similar effects happen for funds that hold futures, which record an official settlement price at 2:30 p.m. ET, and for physically held currencies, which, as with EFA, have their exchange rates—and therefore their entire valuation—set at 10 a.m. ET.

NAV Accounting Rules

There’s another aspect of bond ETF valuation that can produce phantom premiums or discounts. Sometimes, bond fund NAVs are calculated using the closing (or modeled) bid rather than the last traded price. That can depress NAV values relative to trading prices, especially if strong market interest tends to promote price discovery.

The iShares iBoxx USD High Yield Corporate Bond ETF (HYG) is a good example. As shown in the chart below, HYG seems to be trading at a persistent premium of approximately 0.25%. 



Yet HYG’s liquidity is exceptionally strong and balanced between buyers and sellers. Even though HYG’s portfolio of high-yield bonds is not easy to arbitrage, HYG nevertheless sees creations or redemptions on a daily basis, evidence that the arbitrage mechanism works. With HYG’s huge volumes, an unwarranted premium should not last for even a minute, and certainly not for half a decade.

HYG’s persistent 0.25% premium is created not by mispricing, but by the way that its NAV is calculated. HYG’s NAV uses a pricing input that reflects the bid price of a bond, not the last traded or estimated midprice. Of course, bids are lower than the midprice, so HYG’s NAV becomes systematically lower than its market price.

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