Exchange traded funds (ETFs) trade on an exchange like a stock and can be bought and sold throughout the day. This is different than the way mutual funds settle; one NAV (net asset value) for all shareholders at the close of the day.

Intra-day fluctuations are quite small because ETFs have a complex arbitrage mechanism that is designed to keep their prices close to their net asset values.  Ian Salisbury of Dow Jones Newswires reports the arbitrage system isn’t flawless, as February 27 proved. The global market correction left some investors with questions. Those who wanted to exit the market as it was heading South could only do so if they took bigger losses than those posted by the ETFs’ underlying stock indexes. The key reason for this is foreign stock index based ETFs trading in the US are subject to the bid and ask prices created by the market maker during trading hours. The volatility of the pricing may be exacerbated at times especially when the foreign markets are closed.

On typical days, most ETFs rarely trade at a difference of more than 1% of their NAVs. Most importantly the premium or discount to the NAV usually comes back in line with the true index value when the foreign market re-opens.

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.