ETFs And Special Situations

[This article comes from the Learn section on our website]

In “Premiums and Discounts,” we introduced and defined the terms, and reviewed how the creation and redemption mechanism usually corrects premiums and discounts. In this article, we’ll take the discussion a step further to highlight some of the more intricate and lesser-known reasons ETFs trade at premiums or a discounts, and what that means to you as an investor.

No one wants to overpay or under-sell when they trade ETFs. In ETF-land, that’s why you hear investors talk about premiums and discounts in frightened tones.

Buy at a premium? Sell at a discount? I’d rather chew on a piece of glass.

But investors who use this as a blanket statement may mis-trade or miss opportunities. It pays to take a step back and understand the intricacies that can lead to premiums and discounts.

When Premiums And Discounts Definitely Matter

Let’s take a case where premiums and discounts definitely matter: domestic ETFs that track domestic equities.

An ETF listed on the London Stock Exchange that holds UK equities should trade spot-on with its iNAV. The reason is that all the securities the fund tracks are trading at the same time as the ETF, so iNAV has live inputs, which makes it a highly accurate representation of the ETF’s current fair value. If the fund trades significantly away from intraday net asset value (iNAV), authorised participants (APs) usually step in to arbitrage the price difference and bring prices back in line. If they don’t, something is usually wrong, such as:

1. - The AP isn’t able to access the underlying securities;
2. - There isn’t sufficient trading volume in the ETF to justify the effort;
3. - Creations or redemptions are halted; or
4. - Other issues are taking place.

In these cases, premium or discounts are likely to be fleeting; eventually the price should snap back into form. When it does, it could cost you. For example, imagine buying a fund at a 5% premium expecting that you’ll be able to sell again at a 5% premium. If the AP steps in and brings the price back in line with NAV, you’re sitting on a 5% loss due entirely to trading (as opposed to investment fundamentals).

Where Premiums And Discounts Are More Challenging

International ETFs

Problems and challenges arise as we expand beyond domestic equity funds.

Take a Chinese equity ETF listed on the LSE. The fund’s NAV and iNAV are based on the last traded price of its securities—which trade in China. As a result, the fund’s iNAV will not change much during the UK trading day (while Chinese equity markets are closed); the only adjustments will be for moves in the currency.

That’s not to say that premiums and discounts in international equity ETFs are always illusory. International ETFs are harder for APs to hedge, which creates the opportunity for real premiums and discounts.

For instance, if there is a large buy order for a China ETF in the middle of the UK trading day, the AP has to fill that orderimmediately. However, the AP can’t hedge the trade and actually acquire the underlying securities until the Chinese market opens later in the day.

With Chinese equity markets closed, the AP lacks a high-quality iNAV from which he can quote prices. Without the price discovery that a high-quality NAV offers, the AP takes on additional risk in quoting this price. To compensate for heightened risk, the AP will usually quote wider bid/ask spreads, which could cause the fund to trade at a meaningful premium or a discount when executed.

As a rule of thumb for ETFs, the greater the trading volume in an ETF, the greater the likelihood that a premium or discount accurately represents the market’s best estimate of the fair value of the ETF.

For thinly traded ETFs, be wary: Premiums and discounts can appear and vanish at random.

Fixed Income And Underlying Markets

Fixed income ETFs are especially susceptible to premiums and discounts, both spurious and real.

We’ve dedicated an entire article to this topic: See “Why do Bond ETFs Trade at Large Premiums and Discounts” for more information on this particular relationship.

Volatility

Periods of high market volatility can also lead to premiums and discounts. There are two main drivers for this:

1. The calculation of iNAV: iNAV is calculated using the last available price of an underlying security with a 15-second lag. During times of high volatility, the ETF’s share price will likely move sharply in response, while iNAV may lag behind.
2. Liquidity Provider Caution: Market makers and liquidity providers are less willing to quote tightly (with regards to bid/ask spreads) during times of high volatility. As a result, investors are more likely to experience wider spreads in trading as well as premiums or discounts in trading.

Taxes

Local taxes in the underlying markets of an ETF’s basket may also contribute to sustained premiums and discounts. When creating shares of an ETF, APs may have to pay local taxes when purchasing the shares of underlying securities. As a result, APs pass on that tax burden in the form of premiums when quoting prices for an ETF to buy-side investors. Depending on the number of buyers versus sellers for a given ETF, the effect of local taxes on premiums can be enhanced or diminished.

Creation/Redemption Halts

At times, ETF issuers may issue halts on creations and redemptions in their funds. As a result, APs are unable to use the create/redeem arbitrage mechanism, leaving an ETF to operate as a closed-end fund with sustained premiums or discounts. Avoid trading an ETF during these periods.

In sum, premiums and discounts are nothing to fear, but it’s important to stay aware of the different dynamics that contribute to them. There are times when they might be justifiable, and periods when they are not.