ETFs publish the net asset value, or NAV, of their underlying holdings throughout the day. When the ETF share price is below the NAV, the fund is said to be trading at a discount. When the share price is above the NAV, the ETF is trading at a premium.
ETFs have a complex arbitrage mechanism designed to keep the share price in line with NAV, so investors get fair prices when they buy and sell.
In illiquid markets, ETFs can trade at premiums or discounts to NAV in times of volatility or heavy buying and selling pressure.
However, in these cases, the deviations to NAV are not proof of a functional problem in ETFs or a breakdown of the arbitrage mechanism.
For example, there have been several media stories recently focusing on the discounts seen in bond ETFs, particularly funds tracking municipal bonds and high-yield corporate debt. The bond market has been under stress on rising interest rates and speculation the Federal Reserve may pull back on monetary stimulus.
Rather than any structural flaw, these “discounts” are actually a reflection that ETFs trade in real time throughout the day. During the recent sell-off, some muni and high-yield bonds simply stopped trading. Therefore, the fund’s NAV isn’t really an accurate indication of real-time value.
This issue is addressed in a 2010 paper by BlackRock fixed-income strategists Matthew Tucker and Stephen Laipply. BlackRock manages the iShares ETFs.
They focused on the 2008 credit crisis when liquidity dried up, and its impact on bond ETFs.
“Credit markets essentially froze, while fixed income credit ETFs continued to trade on the exchange,” the BlackRock strategists wrote. “In some instances, they were the only source of market exposure and price discovery.”
Next page: ‘It’s the correct price’