Morningstar on ETF Premiums and Discounts
February 11th, 2013 at 4:02pm by Tom Lydon
The share price of an ETF doesn’t always perfectly track the value of the securities or assets held in the underlying portfolio. These fluctuations to net asset value are known as premiums and discounts.
However, Morningstar believes that premiums can be predicted and capitalized upon through patient trading.
According to a recent Morningstar research paper, daily changes in ETF premiums show a positive relationship to simultaneous and lagged movements in the equity market, equity market volatility, and equity market liquidity.
“A larger change in one variable today tends to coincide with a larger change to an ETF’s premium both tomorrow and the day after,” Morningstar said.
The findings were based on a hypothetical model with a nine category-specific, value-weighted long-short portfolios composed of U.S. equity ETFs.
“Furthermore, active ETF trading strategies can be created using these relationships as indicators to generate abnormal returns before transaction costs,” the researchers added.
Consequently, investors can potentially use this information to improve trade execution and diminish indirect costs associated with trading at a premium.
“In some cases, putting this knowledge to use for a single transaction could have covered the entire annual expense ratio of the ETF purchased,” Morningstar said.
While this study only covered the U.S. equity market, the author suggests that the same methodology could in theory be used for international ETFs, as well as ETFs in other asset classes like commodities and fixed income.
For more information on ETFs, visit our ETF 101 category.
Max Chen 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.