What Premiums and Discounts Mean for ETFs

Question: In your recent column about emerging markets, you noted that  BLDRS Emerging Markets 50 ADR Index  is trading at a slight premium right now. But when I looked at the most recent data for the fund, I saw that it was trading at a discount. What gives?

Answer: You raise a good question, and on further reflection I can see how users could easily be confused on this front. Morningstar actually includes two sets of premium/discount data for exchange-traded funds. To further complicate matters, one set of premium/discount data is available to all users of the site, while the second set is available only to Morningstar.com Premium members.

Technical, Not Fundamental
Let's start by looking at the premium/discount data to which you were referring--the free premium/discount data for each ETF and closed-end fund on Morningstar.com. You can find this information on the Quote page for each individual ETF under the Prem/Discount heading. In short, these data capture whether the ETF is currently selling at a higher or lower price than the current value of the securities in the portfolio.

Exchange-traded funds have an arbitrage mechanism that helps keep the ETF's share prices in line with the value of their securities, and that's a very effective mechanism much of the time. In the case of ETFs that traffic in highly liquid securities, you'll see that they trade in near-lockstep with the value of the securities they hold. For example,  SPDR S&P 500 (SPY), which owns behemoth companies and has the largest volume of shares changing hands per day, was recently trading at a share price just slightly below the value of the securities in its portfolio. In contrast, UBS E-TRACS Short Platinum ETN , the most thinly traded ETF in our database, was recently trading at a 1.27% premium to its share price. Several bond ETFs have also seen their share prices move out of line with their holdings' prices, a phenomenon that Bradley Kay discussed in depth in this article.

Fundamental, Not Technical
Our other data about premiums and discounts--which I cited in my article about emerging markets and current valuations--is available for equity ETFs only. Found on Morningstar.com ETF Analyst Reports and in Morningstar's  ETF Valuation Quickrank, the data harness our equity analysts' forward-looking view of the fair values of the various companies within a given ETF.

It's important to note that users won't see an actual premium or discount percentage per se, but they will see an ETF's current price as well as our analyst's fair value estimate for it, based on all of the holdings within the ETF. If those companies, in aggregate and on an asset-weighted basis, are trading more cheaply than what our analysts think they're worth, the ETF's fair value estimate will be above the ETF's current price per share. Thus, we'll say that the fund is trading at a discount to our analysts' fair value estimate. That was recently the case with SPDR S&P 500, for example; the fund was trading at a roughly 10% discount to its fair value estimate. In contrast, the BLDRS Emerging Markets 50 ADR Index ETN was recently trading at a slight premium to our analysts' estimates of the fair values of its holdings.

How to Use Them
Our free premium/discount data for each ETF provide a quick view of whether there are any liquidity issues to be mindful of when buying and selling that product. If an ETF has a history of trading out of line with its NAV, you might consider using a limit order rather than a market order to help ensure that your trade is executed in line with your expectations.

Meanwhile, Morningstar's aggregate price/fair value ratios of an ETF's constituent holdings can help you determine whether it's a good or bad time to buy a given ETF. Dollar-cost averaging is a solid risk-reducing strategy no matter what asset you're investing in, but it can make particular sense if you're initiating a new position in or adding to an ETF whose holdings appear substantially overvalued. To help you determine how much weight to put on Morningstar's price/fair value ratios for a given ETF, be sure to check the coverage level for the ETF's holdings. If the coverage is less than 80% of assets, you'll want to discount the estimates accordingly.

Morningstar's ETF Valuation Quickrank, meanwhile, can help you quickly draw a bead on which market sectors appear particularly over- or undervalued based on our analysts' bottom-up research.

See More Articles by Christine Benz

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