Exchange traded funds and closed-end funds are often grouped together, although ETFs don’t exhibit the premiums and discounts seen in closed-end funds.
Why is that?
The answer is the so-called arbitrage mechanism of ETFs. A premium or discount occurs when the price of an ETF share moves away from the net asset value (NAV) of the underlying holdings.
Investors buy and sell exchange-listed ETFs on the secondary market. If there is strong demand for an ETF, a premium to NAV may arise.
Enter the ETF “authorized participants.” These are typically broker/dealers that have the ability to create and redeem large blocks of shares with the ETF portfolio manager.
So if a premium to NAV occurs, the authorized participant could buy the stocks in the ETF portfolio, create new ETF shares and sell them for a risk-free profit, or arbitrage. The reverse process occurs when discounts to NAV break out.
ETFs that track more illiquid markets tend to have larger premiums and discounts. Also remember that some U.S.-listed ETFs that follow international markets may continue trading while their underlying markets are closed.
“Invariably, the market prices of ETFs are going to fluctuate around their NAVs to some extent. While you can’t avoid this characteristic of ETFs, you can choose the price at which you buy and sell a particular ETF by using a limit order,” writes David Suarez at the Schwab Center for Financial Research.
Premiums and discounts are more of an issue for short-term traders rather than buy-and-hold investors.
For more on the basics of ETFs, please visit our ETF 101 category.