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section header ETF fundamentals

subsection header Trading

How do premiums and discounts work?

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.

  • Premiums. When an ETF trades at a price that is higher than its NAV, it is said to be trading at a premium.
  • Discounts. When an ETF trades at a price lower than its NAV, it is said to be trading at a discount.

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.

 

Drivers of ETF premiums and discounts

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:

  • If the underlying securities become less liquid or markets are experiencing heavy order flow, the result may mean higher transaction costs, leading to larger premiums and discounts.
  • If the underlying securities trade on an exchange that is open at a different time than the exchange the ETF trades on, there could be deviations between current and stale security pricing, resulting in larger premiums or 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.

 

Figure 1. Pricing differences can lead to an inherent premium for fixed income ETFs

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.

 

Figure 2. Relative demand can affect premium and discount size

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.

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Basics

Learn the basics of ETFs, including their history, how they compare to mutual funds, what types are available and more.

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Indexing

Learn about the advantages of indexing, how ETFs are indexed, the differences between excess return and tracking error, and more.

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Strategies

Learn about strategic and tactical uses for ETFs, including asset and sub-asset allocation, portfolio completion, cash equitization and more.

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