I have been receiving a lot of questions from financial advisors and investors recently about what exactly is a premium/discount1 for an exchange traded fund (ETF)2. My first response is that investors interested in buying or selling ETFs should carefully consider a range of information, not just premium/discount. Secondly, when considering premium/discount, it’s best to understand what the figure actually represents. I’ll start by defining what is being compared in the premium/discount figure and how it is being calculated; then I’ll explain how the value can be interpreted by investors.
Defining the premium/discount calculation
Simply put, the premium/discount compares the market price of an ETF3 (often represented by a mid-point price) to the ETF’s net asset value (NAV)4. The mid-point price is the mid-point between the bid, or the price an investor could sell an ETF, and the ask, the price an investor could buy an ETF. The NAV is a close of day value for all the securities in the ETF. Unlike a mutual fund that has just one price (the latest NAV), an ETF has these two pricing sources — market price and the latest NAV. The premium/discount calculation is a daily snapshot, specifically at the time the NAV is being struck (typically at the market close). In order to calculate the premium/discount, one takes the difference between the market price and NAV as a percentage of the NAV. A positive number means the ETF market price is trading above the NAV, or at a premium. A negative number means the ETF market price is trading below the NAV, or at a discount. Easy enough? Not so fast.
More calculating: iNAV
To further complicate things, every ETF is required to calculate an intraday NAV (iNAV) during U.S. trading hours so investors have a sense of what the underlying portfolio is worth at a point in time. The iNAV is disseminated every 15 seconds throughout the trading day based on the most recent prices. The ETF market price and the iNAV can fluctuate throughout the day, but the actual premium/discount refers to the end of day difference. Now that I have explained exactly what the premium/discount tells an investor, I will discuss why it may not be very helpful for ETFs that are listed and traded in the U.S but have underlying securities that close at different times, specifically international equity.
Reading the numbers, accounting for time
For domestic ETFs, premium/discount will often remain near zero because the ETF and the portfolio of securities are traded during the same market hours and the values are widely known. By contrast, an ETF with international underlying securities may show greater premium/discount at times because of the nature of the inputs used to calculate each value. To show what I mean, let’s look at a hypothetical example of an international ETF traded during U.S. hours.
When the U.S. markets open, the ETF begins trading and a majority of the international underlying securities have already closed. Once the last international local market closes for the day, the input prices used to calculate the iNAV are fixed and the iNAV should only change based on currency moves for the remainder of the day. However, market makers will apply a fair value methodology to help determine the ETF market price and make real time markets until the end of the U.S. trading day. Market makers have tools at their disposal to manage these timing issues, including futures5, American Depositary Receipts (ADRs)6, and proxy portfolios7 that also trade around U.S. hours. Any news that will impact trading during U.S. hours should be accounted for in real time in the market price of the ETF. Remember, the iNAV represents the most recent closing prices while the ETF market price represents the expectations of the next open in the local international markets at that point in time. Again, the apparent difference emerges because the iNAV is using “stale” closing prices while the ETF market price should account for real time inputs and real trades during the U.S. trading day.
Knowing the numeral
In the end, what is important for investors to take away is that premium/discount can be a useful tool when considering an ETF, but it’s not as useful for an ETF with securities that close at different times. What’s more, financial advisors and their clients may want to consider a range of factors when evaluating ETFs. These include the total cost of ownership (expense ratio and the bid/ask spread), portfolio construction methodology and the expertise of the investment management team. Investors interested in buying or selling international ETFs should carefully consider a range of information, not just premium/discount.
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1 Here, the terms “premium” and “discount” refer to whether or not an exchange traded fund (ETF) is trading at more or less than its net asset value (NAV) or intraday net asset value (iNAV). ETFs trading at a price that is higher (or more than) NAV or iNAV are said to be trading at a premium, whereas ETFs trading at a price lower (or less than) NAV or iNAV are said to be trading at a discount.
2 An Exchange Traded Fund (ETF) is a type of fund that tracks an index, commodity or basket of assets and trades on an exchange.
3 An exchange traded fund’s (ETF’s) market price is the price at which shares in the fund can be bought or sold on the exchanges during trading hours.
4 An exchange traded fund’s (ETF’s) net asset value, or NAV, represents the value of each share’s portion of the fund’s underlying assets and cash at the end of each trading day.
5 Futures are financial contracts obligating the buyer to purchase an asset, or the seller to sell an asset, at a predetermined future date and price. Futures involve a high degree of risk and may result in potentially unlimited losses.
6 An American depositary receipt, or ADR, is a negotiable certificate issued by a U.S. bank representing a specified number of shares in a foreign stock that is traded on a U.S. exchange.
7 A proxy portfolio is a broad representation of the overall market, used to simplify studies that require a market variable, statistic, or comparison.
ETFs trade like stocks, are subject to investment risk, and will fluctuate in market value. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than the ETF's net asset value.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.
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