ETF trading talk is back!

This might come as a shock to many of my readers, but I am not always up to speed on the latest trends in fashion, culture or music. There is a natural cadence in our household where my kids say or reference something at dinner, my wife and I have no idea what they are talking about, and then once I understand, determine if it can somehow be parlayed into an exchange-traded fund (ETF) context for my newsletter. Some of my favorite posts were born this way, such as defining teenage lingo via the ETF ecosystem.

The concept took a completely different turn as my daughter opened her birthday presents last month. There were the usual gift cards and candy. Then, out of the blue, she unwrapped what I thought was a ”fanny pack.” I have not seen these in ages and I am pretty sure if I had worn them two decades ago there would be no wife and no kids in front of me today. I made a comment that was a lame gift when my daughter shook her head sorrowfully: “No dad…that is an everywhere belt bag and they are super cool.”  Oh! Next up was a small instant camera that would immediately allow her to print out 12 photos. I thought instant cameras (Polaroid being the pioneer in 1948) were also a thing of the past. My smartphone has a very advanced camera with thousands of photos I can print at any time. Once again, she shook her head: “No dad…it’s super-fun, and no one prints from their phones!” I guess anything can make a comeback with enough time.

One of my first posts back in 2016 was about misconceptions over ETF premiums and discounts. In my most recent post, I even speculated that ETF trading questions seemed to be on the decline as efficiency and education have increased. Nothing like a little market volatility and uncertainty to bring ETF trading back to the forefront. Time to go back to my roots! And as it pertains to ETF premium/discounts, it’s not a bad time to refresh and update my thoughts from a decade prior.

Definition of ETF premium/discount

The percentage that the ETF closing price is above or below its net asset value (NAV). I emphasize the word “closing” here since the historic premium/discount information available (for example, on ETF issuer websites) only considers the official closing price of the ETF in relation to its NAV.  

ETFs that hold US equities

In theory, these ETFs should have the smallest premiums and discounts since the ETF and the underlying stocks they hold close at the same time (4 p.m. EST). However, they are not immune. Newer funds with slightly wider spreads can have increased premium/discounts depending on whether the last trade occurs on the bid or the offer. Also, without getting too far into the weeds on the mechanics of ETF closing auctions, if there is a significant imbalance of buyers (or sellers) then the ETF final price could rise (or fall) unexpectedly. This dynamic could happen with any ETF, even the most liquid ones.

ETFs that hold international equities

These funds add an extra wrinkle as the underlying international stocks have already closed well before the ETF closes in the United States. The concept of “price discovery” is that the US ETF can serve as a sentiment gauge as to what will happen in those international equity markets the next business day. Larger premiums and discounts in these ETFs are often quite common depending on the extent of the price discovery occurring in the US. Not surprisingly, there were some extreme premiums/discounts in April when the broader market was up/down over 5% multiple times.

One caveat is that different issuers will have different approaches to how to fair value their NAVs during extreme market moves. That makes it challenging to compare the premiums/discounts of ETFs with those of similar underlying equities managed by different issuers. However, the intraday ETF price relative to the official closing price of the international equities should be consistent, even across issuers with different NAV policies as the approach market makers take to pricing closed markets does not depend on NAV policies.

ETFs that hold bonds

When dealing with ETFs that hold equities, often there’s not much thought given to the spread of the underlying holdings. For example, US stocks trade at $0.01 spreads. That is not the case with bonds, which have their own trading ecosystem. One of the beauties of ETF trading is that buyers can transact with sellers on exchanges without the need for market makers to transact in the underlying markets. However, that dynamic does not directly impact the underlying spread of the high yield bonds, bank loans, or CLOs. Market uncertainty certainly can.

Many of the more popular ETFs that hold those three underlying assets saw premiums in excess of 1% and then discounts below 1%, all within a week’s time. That is a healthy reminder that even though the ETF spread might be tight, its price in relation to NAV will be dictated by the buying (or selling) pressure in the market and the price to purchase (or sell) the underlying bonds.

Exchange traded products (ETPs) that hold digital assets

Lastly, our newest entrant to the premium/discount discussion—ETPs. In this case, the underlying asset never closes. For these vehicles, the premium/discount will be entirely dependent on how their NAV is determined. Some ETP issuers will use a digital asset benchmark that tries to take the last price of the underlying digital asset as close to 4 p.m. EST as possible. Those tend to have small premium/discounts. Other issuers will take the average price of the underlying digital asset between 3 p.m. and 4 p.m. EST. These funds can have larger premium/discounts, depending on the price move over the last hour of the ETP’s trading day.

I think that is enough premium/discount talk for one day. Back to my daughter’s birthday, that instant digital camera was cool…the kids had a blast taking pictures and more importantly, their cellphones were nowhere to be found. If bringing back the past is the secret to getting my kids off their phones, then be prepared to be inundated with ETF capital markets trading misconceptions all summer!