What Is a Premium and Discount on an ETF?
Understand the relationship between an ETF's market price and its true value. Learn about premiums, discounts, and how they affect your investments.
An Exchange Traded Fund (ETF) is a type of investment fund that holds various assets like stocks, bonds, or commodities. These funds trade on stock exchanges throughout the day, much like individual company shares. ETFs offer investors a way to gain exposure to a diversified basket of securities or a specific market segment through a single transaction.
Market Price and Net Asset Value (NAV)
The market price of an ETF is the price at which its shares are bought and sold on a stock exchange during trading hours. This price is determined by the continuous interplay of supply and demand from investors in the secondary market. The market price can fluctuate throughout the trading day, reflecting real-time market sentiment.
In contrast, the Net Asset Value (NAV) represents the per-share value of the underlying assets held by the ETF. This value is calculated once per day, typically at the close of the trading day, using the closing prices of all the securities and other assets within the fund, minus any liabilities, divided by the number of outstanding shares. The NAV serves as the theoretical fair value of the ETF’s holdings. The market price constantly changes during trading hours, while the NAV is a static, end-of-day valuation.
Understanding Premium and Discount
An ETF trades at a premium when its market price is higher than its Net Asset Value (NAV). Conversely, an ETF trades at a discount when its market price is lower than its NAV.
The premium or discount is typically expressed as a percentage, calculated using the formula: ((Market Price - NAV) / NAV) 100%. A positive percentage indicates a premium, while a negative percentage signifies a discount. For instance, a 0.20% premium means the market price is 0.20% above the NAV.
Reasons for Premium and Discount
The primary reason for an ETF’s market price to deviate from its NAV is the dynamic balance of supply and demand for the ETF shares on the open market. Authorized Participants (APs), typically large institutional investors or market makers, play a significant role in keeping the market price aligned with the NAV through a process called creation and redemption.
When an ETF trades at a premium, APs can buy the underlying securities, create new ETF shares by delivering these securities to the ETF issuer, and then sell the newly created ETF shares on the market at the higher market price to profit. If an ETF trades at a discount, APs can buy ETF shares on the market at the lower price, redeem them with the ETF issuer for the underlying securities, and then sell those securities. This arbitrage mechanism helps to push the ETF’s market price back toward its NAV. However, this process is not always instantaneous or perfect.
Several factors can cause premiums or discounts to arise or persist:
- Market liquidity: If underlying assets are difficult to trade or the ETF has low trading volume, arbitrage may be less efficient.
- Differences in trading hours: For ETFs holding international assets, underlying markets may be closed when the U.S. ETF trades, leading to a “stale” NAV.
- Market sentiment: Speculative buying and selling pressure on ETF shares can temporarily push the market price away from the NAV.
- Operational delays: Issues within the creation/redemption process can lead to persistent deviations.
- Valuation challenges: Difficulty in valuing complex or illiquid underlying assets can also contribute.
Investor Awareness
A substantial premium means an investor is paying more than the intrinsic value of the ETF’s underlying assets. Conversely, a notable discount suggests an investor is acquiring the ETF shares for less than the current value of those assets.
Investors should consider checking an ETF’s premium or discount before making a trade, particularly for ETFs that track international markets or hold less liquid assets. Small, consistent premiums or discounts, often less than 0.1% or 0.2%, are common for highly liquid ETFs and are generally not a major concern for long-term investors. However, large or consistently volatile deviations could signal potential issues with the ETF’s liquidity, the efficiency of its arbitrage mechanism, or the underlying market conditions. Many ETF providers and financial data platforms offer premium/discount data, allowing investors to monitor these values and make more informed investment decisions.