Understanding premiums and discounts for ETFs

The important thing to remember is that ETFs generally trade close to their fair value, and premiums or discounts tend to be short-lived.

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Confusing as it seems, ETFs have more than one "price."

First, there’s its actual value, which is measured by net asset value (NAV) at the end of each day and by intraday NAV (iNAV) in the middle of the day.

However, because ETFs trade on an exchange, they also have a current market price—which could be more or less than its actual value.

In short, if the price of the ETF is trading above its NAV, the ETF is said to be trading at a “premium.” Conversely, if the price of the ETF is trading below its NAV, the ETF is said to be trading at a “discount.” In relatively calm markets, ETF prices and NAV generally stay close. However, when financial markets become more volatile, ETFs quickly reflect changes in market sentiment, while NAV may take longer to adjust—resulting in premiums and discounts.

Why?

This can happen throughout the trading day, because the ETF and its underlying securities are actually two distinct liquidity pools that are only loosely linked.

If optimistic investors start bidding up an ETF aggressively—more so than its underlying securities—the price of the ETF may rise faster than the price of its underlying securities and, consequently, it may trade at a premium. Similarly, if pessimistic investors sell an ETF aggressively, more so than its underlying securities, the ETF may trade at a discount.

Alternatively, premiums or discounts may arise because the ETF and its underlying securities trade on exchanges that are in different time zones.

Consider the scenario of ETFs listed on the NYSE that track the FTSE 100. It’s not uncommon for those ETFs to trade significant volume after the London Stock Exchange closes at 11:30 a.m. ET. The price of these ETFs will reflect real-time changes in market sentiment, while NAV will be based on stale prices from the earlier LSE close.

In this case, any significant deviation between ETF price and NAV will likely vanish when both exchanges are open at the same time.

How are premiums and discounts corrected?

Thanks to the creation/redemption mechanism, deviations between ETF price and its NAV tend to be short-lived. That said, not all premiums and discounts quickly self-correct; some persist for a variety of reasons. In order for an authorized participant (AP) to create or redeem shares quickly, he or she needs access to the underlying securities—which is not always possible.

Sometimes access is just a time challenge: For ETFs holding international securities, there could be a delay before the AP is finally able to access the underlying market and effectively create or redeem ETP shares—the delay can lead to temporary premiums and discounts.

Other times, restricted access to the underlying securities could be symptomatic of more serious structural problems. Depending on the severity, the issuer may even have to halt the creation of new ETF shares.

During the Arab Spring, for instance, ETFs tracking the Egyptian markets shuttered, leading to wild swings in the perceived premiums of those ETFs. In these cases, the ETF effectively starts trading like a closed-end fund, and can trade at constant premiums until creations are resumed, when such premiums usually vanish.

The important thing to remember is that ETFs generally trade close to their fair value, and premiums or discounts tend to be short-lived. However, that’s not always the case, so dig deeper before snapping up a fund simply because it’s trading at a discount (you may have to sell at a bigger discount). Lastly, use limit orders set close to NAV to prevent buying at a large premium or selling at a large discount.

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Article copyright 2014 by ETF.com. Reprinted with permission from ETF.com. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.

Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange-traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETP's shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.

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