Typically, demand is a major determinant of premiums or discounts, since strong demand would make the ETF price rise quickly above its NAV, causing a premium, or low demand may allow the underlying securities to appreciate above the ETF’s price, causing a discount. The imbalances between supply and demand are particularly noticeable within illiquid markets that offer limited access to the underlying assets, such as in the emerging markets. Additionally, international ETFs also track securities traded on different time zones, which produces a time lag to between the ETF and its NAV. Commodity ETFs may be restricted by position limits on futures contracts and trade at a steady premium to underlying commodity prices.

Tthe investor will realize an indirect transaction cost when the premium drops or the discount widens. Conversely, if the premium to NAV increases or the discount diminishes, an investor may see a small boost.

In large liquid markets, so-called authorized participants tend to take advantage of the ETF arbitrage system to capitalize on any discounts or premiums as they create or redeem shares to bring the ETF price closer to the NAV. [What is an ETF? — Part 4: In-Kind Creations and Redemptions]

For past stories in this series, visit our “What is an ETF?” category.

Max Chen contributed to this article.

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