Premiums and discounts are an important factor to consider before investing in an exchange traded fund. In today’s market it is important to check into why these conditions exist.
The importance of a premium or discount comes into focus when one is considering investing in a niche or less-liquid ETF. The cause of a premium or discount can be explained, and may give insight into the near future health of the investment. [What are ETFs? Portfolio Building Blocks]
“Another rational explanation for premiums and discounts is based on the nature of the underlying assets. Because many bonds trade infrequently, they sell at wider bid-ask spreads. When quoting the value of a bond, it is common to use the midpoint of the bid and ask. But you have to pay the ask when buying the bond or when there are large inflows into a bond ETF, making the ETF look as if it is trading at a premium,” Michael Rawson for Morningstar wrote in a recent article. [What is an ETF? Premiums and Discounts]
A premium or discount occurs when investors bid the market price of an ETF above or below the NAV of its basket of stocks. If the bid is higher than the net asset value (NAV) the fund is trading at a premium, and if the bid is lower, it is trading at a discount. Furthermore, a premium occurs when investors are optimistic about a certain fund, which is usually fueled by investor’s opinions. [ETF Tracking Error Declines]
Another explanation of why a premium or discount exists in an ETF is when the market for the assets underlying an ETF trade at different hours than the ETF itself. This can create a lag in the market that is operating in a different time frame than the targeted equity market, but it serves as a price discovery mechanism rather than a token of an inadequate market.
Tisha Guerrero contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.