An ETF typically trades at a price that is close to the net asset value (NAV) of its underlying securities.
However, due to 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 dealers 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 AP can capitalize on the price difference via the ETF creation/redemption process. Creations and redemptions help to bring the supply of ETF units 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 supply and demand of ETF units and the underlying securities.
Two additional considerations related to premiums and discounts:
When the cost of transacting in the underlying securities is higher, the ETF arbitrage band will be wider, this may result in a wider range of premiums and discounts.
If the underlying securities trade in a market that is open at a different time than the exchange the ETF trades on, there could be deviations between current and stale security pricing, which can result in perceived premiums or discounts.
ETFs in some asset classes—for instance, fixed income—tend to have relatively large and constant premiums and discounts. A major reason for this occurrence is the pricing difference between the ETF and the underlying bonds.
Figure 1. Pricing differences can lead to an inherent premium for fixed income ETFs
Source: Vanguard.
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
Source: Vanguard.
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.
Points to consider
The spread on the underlying holdings has a clear impact on premiums and discounts, since it determines the ETF's trading range. Here are some considerations across asset classes:
Fixed income
Government bonds tend to be liquid, with narrower and more consistent bid-ask spreads, causing government bond ETFs to trade with smaller premiums and discounts. Corporate bonds tend to be less liquid, with wider and often more volatile bid-ask spreads. As a result, corporate bond ETFs tend to trade with larger premiums and discounts.
Equities
Large-capitalization shares tend to have narrower spreads, causing large-cap ETFs to trade with fewer premiums and discounts. Small-cap shares tend to have wider spreads, causing small-cap ETFs to have relatively larger premiums and discounts.