section header ETF fundamentals
subsection header Trading
An ETF typically trades at a price that's close to the net asset value (NAV) of its underlying securities.
However, because of factors such as trading hours and market liquidity, an ETF's market price might be higher or lower than its NAV.
Authorized participants help to keep the ETF's market price in line with the value of its underlying securities. If a significant premium or discount develops, an authorized participant can capitalize on the price difference through the ETF creation/redemption process. Creations and redemptions help to bring the supply of ETF shares more in line with demand, which in turn helps to bring the ETF's market price more in line with the value of its underlying securities.
The appearance of premiums and discounts is a natural outcome of the relationship between the ETF and its underlying securities.
Two key factors can drive premiums and discounts:
Many ETFs, notably domestic equity ETFs, have smaller premiums and discounts since they trade at the same time as their underlying market. Note also that large-capitalization stocks tend to have narrower spreads, causing large-cap ETFs to trade with fewer premiums and discounts. Small-cap stocks tend to have wider spreads, causing small-cap ETFs to have relatively larger premiums and discounts.
A Vanguard fixed income ETF's end-of-day market price is calculated as the midpoint of the best bid and ask at 4 p.m., Eastern time, while the underlying bonds in the fund are valued at their bid prices for the purposes of determining NAV (Figure 1). This pricing difference results in an inherent premium since the midpoint of the bid-ask spread on the ETF is typically going to be higher than the bid price of the underlying bonds. It is important to consider that while this structural difference leads an investor to buy at a premium, there is a higher probability of also selling at a premium.
The level of premium or discount will also vary depending on the demand for the ETF relative to the flow in the market. The greater the relative demand to buy the ETF, the higher the bid-ask quote and thus the higher the midpoint of that quote (Figure 2). This could result in a larger premium. The opposite is also true: If there is greater demand to sell the ETF, its premium could fall and perhaps result in a discount.
Fixed income ETF premiums and discounts can be somewhat misleading because transaction costs are more transparent with ETFs than with traditional mutual funds. In times of heavier order flow or less liquidity, the bid-ask spreads of the underlying securities could widen to reflect the current market situation, leading to larger premiums and discounts for fixed income ETFs. A mutual fund portfolio manager trying to buy or sell the same basket of bonds may also be paying the same bid-ask spread; however, investors do not see those costs in real time. Instead, these costs are reflected after the fact as part of the fund's NAV. To put a fine point on it: premiums and discounts in fixed income ETFs are largely a reflection of the externalization of investors' transaction costs.