ETP Premiums and Discounts: Look Before You Leap
While most premiums and discounts are benign, it pays to check the numbers.
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.
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.
Michael Rawson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.
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