Exchange traded funds continue to increase in number and popularity, growing to one of the most commonly traded securities on the stock exchange as both institutional and the average retail investor gain greater access to broad or specialized market exposure. Yet many individuals are unfamiliar with ETFs’ inner workings. In this ongoing series, we hope to address your questions and help shed light on the investment vehicle. [What is an ETF? — Part 5: Know Your Holdings]
ETFs try to reflect the performance of an underlying bundle of securities as closely as possible, but there are times when a fund may trade at a premium or discount to its underlying holdings.
But why?
The answer lies within the ETFs “arbitrage mechanism.” When an ETF’s price deviates from its net asset value (NAV) of the underlying holdings, a premium or discount manifests.
The NAV is calculated by dividing the value of all securities in the portfolio by the number of outstanding shares, and the market price of an ETF is determined by its underlying shares. Since an ETF’s price is constantly shifting during the day, a price difference may emerge between the price of the ETF and its NAV.
When the ETF’s price is lower than the NAV, the ETF is said to be at a “discount” – the ETF is valued less than the fund’s overall holdings. If the ETF’s price is above the NAV, the ETF is said to trade at a “premium” – the ETF is trading higher than what the underlying holdings are worth.