Understanding premium and discount
“ETF trading at a premium?” or “What’s the deal with ETF B selling at a loss?” Y. These are some questions you are likely to hear whenever advisors talk about ETFs. You can understand this better if you understand the different costs of ETF transactions.
ETFs have multiple “prices,” as perplexing as they may appear. There’s the actual value, determined by the net asset value (NAV) after each day and the intraday NAV (iNAV) in the midst.
The NAV of bond ETFs is set by the bid prices of the portfolio’s underlying bonds. The NAV of an equity ETF is given by the most recent trading prices of the underlying stocks. The NAV is calculated based on the previous trading day’s closing.
However, since ETFs are actively traded on a stock exchange, they have a current market price which may differ from their actual value. This market price will determine the premiums and discounts.
The ETF’s latest traded price determines the market price of both equities and bond ETFs. For a stock ETF, that price will often fall within the bid-ask spread of the underlying basket of securities, but bond ETFs would more likely trade at a premium because the NAV is set at the lesser bid price.
If the price of an ETF is higher than its determined NAV, it trades at a “premium.” In contrast, if the ETF’s price is below its NAV, it trades at a “discount.”
ETF prices and NAV are often closed in relatively calm markets. When stock markets become choppy, however, ETFs respond swiftly to shifts in market sentiment, whereas NAV may take longer to adjust, leading to premiums and discounts.
Let’s look at it illustratively,
The market price of an equity ETF will often fluctuate within the basket’s bid-ask spread. When the ETF’s supply and demand are roughly balanced, trading takes place on the secondary market.
The ETF’s market price may be momentarily pushed outside the limitations of the fundamental basket when there are more buyers and sellers in the market. Traders might profit from the gap between the ETF’s market rate and the prices of the underlying securities if the ETF trades at a significant premium or discount.
When this occurs, the market maker can go to the primary market to deal with the ETF sponsor, issuing new ETF units when prices increase and redeeming ETF units when supply is low.
The primary market aids in re-aligning the ETF market price with the NAV. However, because the expenses are determined by the creation/redemption process, the ETF would often trade at a higher premium or discount to mirror those costs until the two-way order flow in the ETF recovers.
Since the ETF and its fundamental securities are two separate liquidity pools that are only loosely connected, this can happen at any time during the trading day.
Suppose bullish investors start bidding up an ETF more aggressively than its underlying securities. In that case, the ETF’s price may climb faster than the underlying securities’ price and, as a result, trade at a premium.
Similarly, if bearish investors sell an ETF aggressively, it may trade at a discount to its underlying stocks. Alternatively, premiums or discounts may develop if the ETF and its constituent stocks trade on exchanges in separate time zones.
Pricing transparency is offered through ETFs, which allow you to acquire the intraday price of any asset type. The problem is that the trade costs are explicit unlike mutual funds, they are not reduced to a single number by the end of the trading day.
It’s critical to keep trading expenses in mind, especially in less liquid markets, and to resist following the herd, which can lead to acquiring at a markup and selling at a discount.
Despite their “designed for speed” nature, ETFs are still the best choice for long-term exposure to specific asset classes.