A Closer Look at How ETFs Track a Basket of Securities

Exchange traded funds are easy-to-use investment tools that help investors track various market segments, but how are ETFs fairly priced?

ETFs hold a basket of securities, including stocks, bonds and/or cash, so an ETF’s share price is affected by the total value of its underlying components, which may fluctuate throughout the day. Consequently, ETF investors should consider the net asset value, or NAV, when deciding if they are getting their money’s worth with an ETF investment.

The NAV is the total value of an ETF’s assets less the total value of its liabilities, which include fees owed to the fund company, writes Ben Johnson, director of global ETF research for Morningstar. To calculate an ETF’s NAV, divide the total NAV minus liabilities of the fund by its number of outstanding shares.

Since ETFs provide intraday liquidity, allowing investors to trade throughout the day at the prevailing market price, the ETF industry has come out with the indicative net asset value, or iNAV, to help investors see whether they are paying or receiving a fair price throughout the day. The iNAV is calculated by the ETF’s listing exchange at regular intervals, typically every 15 seconds, through normal hours. Investors can look up a fund’s iNAV by searching for ^TICKER-IV on Yahoo! Finance.


However, investors won’t likely execute trades that perfectly reflect the iNAV, so the indicator is more of a guide to fair market value. Consequently, ETF trades may come at a slightly premium or discount to their net asset values.

“If a fund’s market price is higher than its iNAV, it is said to be trading at a premium, which is good for sellers and bad for buyers,” Johnson said. “When the market price is lower than the NAV, the ETF is trading at a discount, which helps buyers and harms sellers.”

When an ETF shows a large disparity or wide premium and discount to its NAV, market makers may step in to arbitrage the difference away and bring an ETF’s price back in line with its underlying value.

Authorized participants, or APs, are a special group of market makers with the ability to create and redeem new ETF shares through a fund’s sponsor by exchanging a predetermined basket of securities or cash for new ETF shares and vice versa. If an ETF’s market price deviates too farm from its NAV, market makers will profit from the relative mispricing between the ETF’s price and the aggregate of the underlying securities.