Understanding and Navigating ETFs' Premiums and Discounts

The exchange-traded fund marketplace is littered with a variety of terms and acronyms that have left many investors in want of a user's manual. From time to time, it is worth going back to basics to better understand the ins and outs of ETFs' mechanics to help investors use them to their best advantage. Here, I will discuss net asset value: what it is, why it matters, and how to make sure you are buying shares of an ETF at a fair price.

What Is NAV? Net asset value is the total value of an ETF's assets less the total value of its liabilities. The composition of an ETF's assets will vary but will generally comprise stocks, bonds, and/or cash. If the fund uses physical replication to track its benchmark (that is, it owns securities, not derivatives), the assets are the component securities (or a sampling thereof) of its benchmark index, any accrued income generated through securities lending, and some cash. Liabilities for ETFs and other funds will largely consist of fees owed to the fund company. An ETF's NAV per share can then be calculated by dividing the total NAV of the fund by its number of outstanding shares.

NAV = (Total Value of Assets - Total Value of Liabilities) / Number of Shares

What Is iNAV? Traditional open-end mutual funds calculate their NAV once per business day, after most exchanges have closed and third-party pricing services have disseminated up-to-date price information for various securities. Funds use that value as the price for new purchase or redemption orders placed throughout the day. New investors will purchase fund shares at end-of-day NAV (less any fees), and investors exiting funds will also do so at end-of-day NAV (again, less any fees). This single price for purchases and sales, set using end-of-day prices for all the assets in the portfolio, helps make purchases of traditional funds simple and typically fair.

ETFs offer intraday liquidity. They are priced throughout the trading day and purchased or sold at the prevailing market price. Thus, a regular intraday measure of these funds' NAV is useful in gauging what their portfolios are worth during the trading day. This in turn can help investors see whether they are paying or receiving a fair price. This intraday portfolio value is called the fund's indicative net asset value, or iNAV. The iNAV is calculated by an ETF's listing exchange at regular intervals (usually every 15 seconds) throughout the course of the trading day. However, unlike traditional open-end mutual funds, ETF investors trading during market hours will not typically transact at the most recent iNAV (which is mostly symbolic, a touchstone of sorts). Instead, ETF investors will likely execute their trades at a slight premium or discount to a fund's iNAV.

Premiums and Discounts ETFs' market prices will generally not track their iNAV in lock step. If a fund's market price is higher than its iNAV, it is said to be trading at a premium, which is good for sellers and bad for buyers. Paying $50.49 for a fund whose component securities are worth $49.99 in aggregate will inherently harm your expected returns (assuming you're using the prevailing iNAV as your starting point in this calculation). When the market price is lower than the NAV, the ETF is trading at a discount, which helps buyers and harms sellers. Paying $49.99 for a share in a fund whose component securities are worth $50.49 could only improve your expected returns.

Luckily, ETFs typically trade at prices that are very close to NAV. Even the examples above, of a 1% premium or discount, would be an exaggeration for nearly all ETFs. This is because any premium or discount that arises presents an arbitrage opportunity for authorized participants, or APs--a special "breed" of market makers with the ability to create and redeem new ETF shares directly with a fund's sponsor. APs are able to freely create and redeem ETF shares by exchanging a predetermined basket of securities and/or cash for new ETF shares and vice versa. If an ETF's market price strays too far from its NAV, market makers will move to profit from the relative mispricing between the fund's market price and the aggregate price of its underlying securities.

For example, if the component securities of a given index are worth $49.99 per ETF share and the ETF's shares are changing hands for $50.49 each, a market maker can deliver that basket of securities to the ETF provider in exchange for new ETF shares and subsequently sell the new ETF shares on the open market. The market maker will pocket a small profit for the effort (which will likely be less than $0.50 per ETF share given the costs involved in this process). As market makers compete for these opportunities to make a quick low-risk profit, they serve to minimize the size and persistence of premiums and discounts for the fund's shares.

Source: Morningstar.

The accompanying exhibit is a testament to APs' hard work. It is a histogram showing the distribution of the median of monthly premiums and discounts for the 536 ETFs for which Morningstar has this data available going back 10 years. You'll notice that sizable and persistent premiums and discounts are the exception rather than the rule. In fact, 379 (86%) of the ETFs in this group have tended to trade at a premium/discount to their NAV that ranged from negative 0.05% and 0.05% during the period in question. But there are exceptions to account for.

Source: Morningstar Direct. Data from March 2009 to February 2019.

Examples of Persistent Premiums and Discounts Of the 536 ETFs included in the sample I've referenced above, those that have exhibited the largest and most persistent premiums and discounts share some common characteristics. Of the 20 funds that had the largest median premium or discount during the past decade, six were international-equity funds. The stocks in these funds' portfolios trade on exchanges outside the United States, and their home exchanges' trading hours may have little or no overlap with U.S. trading hours. During these nonoverlapping hours, there is no real-time price information flowing from their constituent securities' home markets. In these windows, the funds effectively serve as "price discovery" vehicles, with buyers and sellers agreeing on fair values for a basket of stocks or bonds that may not be currently changing hands in their local markets. Thus, these premiums and discounts are part of the normal course of business in those cases where trading of an ETF's shares and trading of its portfolio holdings are out of sync.

Bond ETFs represented nine of the remaining 14 ETFs from the 20 that had the largest median premium or discount in the past decade. Premiums and discounts for bond ETFs are typically driven by 1) differences in the way bonds and the ETFs that hold them are priced and 2) costs. For example, at the end of a trading day, a bond ETF will be priced at the midpoint of the prevailing best bid and offer for its shares. However, its NAV will typically be calculated using the bid price for the fund's bonds. The end result is an apparent premium (that is, the ETF shares will be priced higher than NAV). Costs are also a factor. A fund's premium or discount will have to be sufficiently large to give an AP incentive to step in and exploit the arbitrage opportunity--as represented by the transaction cost and compensation for risk threshold in the accompanying exhibit. These costs, and hence this threshold, are typically far greater in the bond market, which is inherently less liquid than the market for stocks.

Examples of Episodic Premiums and Discounts There have been instances of temporary premiums or discounts for ETFs. These have typically been driven by dislocations in the market for ETFs' constituent securities. For example, in the darkest days of the 2008-09 market meltdown, premiums for some fixed-income ETFs showed some staying power. During this period, some fixed-income ETFs became a source of liquidity for holders of these funds' underlying securities, who had almost no way to sell individual bonds on the market. For example, based on daily data collected by Morningstar, iShares iBoxx $ Investment Grade Corporate Bond ETF LQD traded at a persistent premium to NAV for the period spanning from Lehman Brothers' bankruptcy in September 2008 through early 2009. During this span, the average daily premium was 2.3%.

There have been other event-driven dislocations that have served as not-so-gentle reminders of the importance of understanding ETFs' underlying mechanics. On Aug. 24, 2015, many ETFs briefly traded at substantial discounts to their true value. An early-morning sell-off tripped circuit breakers that temporarily suspended trading in a number of stocks and, as a result, many ETFs that held those same stocks. Some investors fell victim to this downdraft, having placed trailing stop-loss orders in these funds' shares that became market orders at precisely the wrong time. Others were able to capitalize on this situation, placing buy orders for baskets of blue-chip stocks at bargain-basement prices. Episodes like these underscore the importance of assessing market conditions prior to trading ETF shares and practicing safe trading.

How Can Investors Monitor and Manage Premiums and Discounts? There is nothing investors can do to directly manage the inevitable premiums and discounts to NAV that exist in the ETF market. Fortunately, these discrepancies tend to be fairly small and fleeting, thanks to the profit-seeking behavior of fiercely competitive market makers, so this should not be a major concern for most long-term investors.

However, when trading ETF shares, it is worth checking whether your buying or selling price is close to its iNAV. Not all brokerages make this information available. Fortunately, Yahoo Finance disseminates iNAVs for ETFs. You can find a fund's iNAV by searching for ^TICKER-IV using the symbol lookup field. For example, you can find the iNAV for Vanguard Dividend Appreciation ETF VIG by looking up ^VIG-IV.

While iNAV is a useful touchstone, the prevailing market price is often the best indicator of a fund's going value. At any given time, market makers and other investors place their bid and ask prices on either side of their estimate of an ETF's fair value. If the bid and ask quotes are only a penny or two apart, the midpoint of the two numbers is probably an even better approximation of the NAV at that time. This is because supercompetitive market makers are leveraging their own proprietary pricing models to assess ETFs' fair values at hyperspeed during the course of the trading day in an effort to maintain their "edge" versus their competitors.

But the best way to protect oneself from these dislocations is to practice safe trading. In all cases, using limit orders is good practice. Limit orders will ensure favorable execution from a price perspective. A buy limit order will fetch the buyer a price less than or equal to the limit price, while a sell limit order will transact at a price greater than or equal to the limit price. What is the potential cost of using limit orders? Time and incomplete execution. That is, it may take longer for a limit order to be filled than a market order, and when that time comes it might not be completely filled. These costs need to be weighed against the cost of being exploited by an opportunistic market maker looking to pick off market orders in thinly traded ETFs.

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