ETP Premiums and Discounts: Look Before You Leap

I have a confession to make. I was wrong about exchange-traded product premiums and discounts. When giving my "ETFs 101" presentation over the past couple of years, I would often get asked questions about ETP premiums and discounts. To keep it simple, I responded that it was typically not something to worry about. After all, in an efficient market, there would be no premium or discount, at least not one that could be arbitraged. If there was, traders would utilize the ETP creation and redemption process to arbitrage it away. But just in the past few weeks, the market has witnessed two ETPs trading at sizable premiums for no good reason. This has forced me to change my views. I realize now that it is important to check for premiums and discounts before trading less-liquid or exotic ETFs. If you notice one, you had better do your homework as to why it exists before you step in.

Foreign Markets
There are a couple of rational explanations for why premiums and discounts exist in ETPs. One example is when the market for the assets underlying an ETF trade at different hours than the ETP itself, such as when the U.S. ETF  iShares MSCI Japan (EWJ) trades when the Japanese market is closed. After the tsunami in Japan last year, two more blasts from nuclear reactors led to market declines of 8% in the net asset value of the ETF. However, as the situation appeared to get better after the market closed in Japan, the ETF began to recover in the United States and eventually closed at a 6% premium. Were investors who bought the ETF at a 6% premium getting a bad deal? No, because when the Japan market opened
the next day, stocks immediately moved higher, closing the gap. In essence, the premium in the ETF was serving as a price discovery mechanism, not a sign of inefficient markets.

Less-Liquid Markets
Another rational explanation for premiums and discounts is based on the nature of the underlying assets. Because many bonds trade infrequently, they sell at wider bid-ask spreads. When quoting the value of a bond, it is common to use the midpoint of the bid and ask. But you have to pay the ask when buying the bond or when there are large inflows into a bond ETF, making the ETF look as if it is trading at a premium. This premium can not be arbitraged away, forcing bond ETFs like  Vanguard Intermediate-Term Corporate Bond Index ETF (VCIT) and Market Vectors International High Yield Bond ETF (IHY) to trade at a consistent but small premium.

Access Vehicles
In order to gain access to a restricted or hard to invest in market, you sometimes have to take what the market gives you. ETFs such as  CurrencyShares Chinese Renminbi Trust  and  Market Vectors China ETF  give investors access to the tightly controlled Chinese market. We call these types of ETFs access vehicles more so than tracking vehicles. The premium may cause the ETF to underperform its index, but there is no other simple way for the retail investor to gain access.

Previously, I thought that premiums and discounts could be explained by the above three explanations, in which case there would be no need to check a fund's premium or discount before trading. My view began to change when  VelocityShares Daily 2x VIX Short Term ETN  stopped allowing new creations of the fund. At that point, the fund essentially began trading like a closed-end fund and the premium widened to 89%. Once the restrictions on creations where lifted, the premium rapidly reversed and the market price dropped 50% in two days while the NAV fell by only 12%. A similar phenomenon is now occurring with iPath DJ-UBS Natural Gas Total Return Sub Index , which currently trades at an 80% premium.

Exchange-traded notes are technically not funds but fall under the umbrella term of exchange-traded products. They are debt obligations of the issuing bank, and the bank can stop issuing new shares if it is in its own best interest. The bank is out to help itself by obtaining low-cost funding, and those interests might conflict with the interests of shareholders. For most ETFs, the bigger the fund the better. But for exotic ETNs, the bigger the fund, the more expensive the hedging costs. So, ETN investors can become victims of the ETN popularity. In fact, we looked at the volatility of the premium and discount across all different product types, and ETNs had the most volatile premiums and discounts. The volatility of premiums and discounts for ETNs was three times greater than 1940 Act open-end funds.

I feel that you still do not need to worry about premiums and discounts in most plain-vanilla stock ETFs.  SPDR S&P 500 (SPY) and  iShares S&P 500 (IVV) trade with premiums of a couple of basis points. That market is easily arbitraged.  On the other hand, check for premiums when trading ETPs holding assets such as commodities or especially when trading ETNs.  You can find premiums on the Morningstar.com Quote page. At worst it will cost you a few seconds; at best it will save you from a bad trade.

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Disclosure: Morningstar, Inc., receives fees for licensing its indexes to ETF/ETN providers. These fees are mainly based on fund assets under management. BlackRock Asset Management; First Asset; First Trust; Invesco; Merrill Lynch; Northern Trust; and Scottrade currently license Morningstar Indexes. These ETFs and ETNs are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on the Morningstar Indexes.