Examining the Exchange-Traded Nature of Exchange-Traded Funds

Exchange-traded funds (ETFs) are still a relatively new investment technology possessed with their own intrinsic and poorly understood peculiarities. As their name implies, ETFs trade on public exchanges. This leaves them susceptible to periodic and sometimes persistent dislocations between their market prices and their underlying net asset value (i.e. premiums and discounts). Until very recently, little formal work has been done to examine and explain the size, nature, and evolution of ETF premiums and discounts over time. This paper proposes a new methodology to model ETF premiums and, for the first time, present empirical data on the time-series evolution of ETF premiums and discounts.

From the investors’ perspective, knowing and using this information properly can improve trade execution and save money. In some cases, putting this knowledge to use for a single transaction could have covered the entire annual expense ratio of the ETF purchased. For the ETF investor, the conclusions of this paper suggest that cost-conscious investors should seek to trade ETFs intelligently and patiently using information readily available today in order to avoid transacting at unfavorable prices tomorrow.

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