Exchange traded funds (ETFs) are an inexpensive way to gain exposure to a wide range of asset classes and are easily traded on a stock exchange. However, unlike stocks, the issue of discounts and premiums may come up sooner or later when trading with ETFs.
All ETFs have a net asset value (NAV), which is calculated by dividing the total value of all the securities in the portfolio by the number of outstanding shares. The market price of an ETF is determined by its underlying shares.
Since ETFs are traded on a stock exchange and priced continually, it means that the ETF’s price is constantly shifting. Because that price moves freely, a price discrepancy may occur between the price of the fund and its NAV.
If the price of a fund is lower than its NAV, the ETF is trading at a “discount” – you’re buying the ETF for less than the value of the fund’s holdings. If the price of the fund is higher than its NAV, the ETF is trading at a “premium” – the amount you’re paying is a little more than what the underlying holdings are actually worth.
Here’s an example:
- If the NAV of an ETF is $30 and the ETF is trading at $25, it’s trading at a discount.
- If the NAV is $30 and it’s trading at $31, then it’s trading at a premium.
What does this mean? When you’re buying, generally not much. But when you sell, the movement from the discount or premium will affect your overall return. The more you trade, the more evident this impact will be. Buy-and-hold investors may not be as concerned with this issue.
It should be noted that buying an ETF at discount or selling at a premium doesn’t necessarily determine profitability, since it is the movement in the discount/premium from time of purchase to time of sale that affects returns.
High-yield bonds, emerging markets and some commodity ETFs may have higher discounts and premiums as compared to other asset classes. ETFs that track U.S. equities or U.S. sovereign debt typically exhibit small discounts and premiums since both securities trade in the open markets and benefit from high levels of supply and demand.
Authorized Participants (APs)
Institutional investors who have a contractual relationship with an ETF create or redeem shares to provide efficient pricing for ETFs. Through arbitrage trading, these authorized participants (APs) try to keep ETF trade prices close to their NAVs.
When ETFs trade above their NAVs, APs buy large blocks of ETF shares at the NAV by engaging in a transfer-in-kind transaction, or a “creation.” APs would then pocket the spread between the NAV and the market price, essentially gaining a risk-free profit by selling the ETF. The reverse also occurs when the ETF trades below its NAV. It is usually in the AP’s own interest to correct the deviation of an ETF’s price from its NAV since any large deviations provide a profit opportunity for APs.