ETF Capital Markets Desk: A Look at Premiums and Discounts

David Mann, our head of capital markets, Global Exchange-Traded Funds (ETFs), has been recently asked why the performance of an ETF may differ from its net asset value (NAV). He discusses what causes a premium or discount, and why it matters—or doesn’t.

I have previously discussed ETFs that trade in line with the value of their underlying basket of securities. The “official” way to keep score on this is to take the closing price of an ETF and compare that with its official end-of-day net asset value (NAV), which is calculated based on the closing price of the underlying securities.

As an example, if an ETF closed at $100.20 and its NAV was at $100, then the ETF would have closed at a 20 basis-point (bps) premium. (One basis point being equal to 1/100^th of a percent, or 0.0001 in decimal terms). Investors want this number to be as small as possible, given the ETF’s goal is to trade in line with the value of its basket.

This concept also works in reverse. For example, if the ETF closes at $99.80, the discount would be 20 basis points.

Recently, I have received some questions as to why the performance of an ETF would be different from the performance of its NAV over a given time frame. Whether an ETF closes at a premium or a discount on a particular day could cause the ETF to outperform or underperform its NAV.

Let’s explore the concept of a premium or discount further.

Once again as an example, let’s say we have an ETF and its NAV is always $100. On December 31, the ETF closes at $100.20 (a 20 bps premium to its NAV) while on March 31, the ETF closes at $99.80 (a 20 bps discount to its NAV). When looking at performance, the NAV return would be flat while the ETF return would be down 40 bps. That leads to the inevitable question of, “why is your ETF underperforming its NAV?” and “what is causing this tracking error in your ETF?” That is, what accounts for the difference between a portfolio's returns and a benchmark, in this case, the ETF's NAV?

When discussing how an ETF performs compared to its NAV over a given time frame, we really want to understand what causes the premium/discount in the first place. For ETFs, there are two main drivers of a premium/discount.

1. Price Discovery

There are many US-listed ETFs that hold securities in underlying markets which are closed during the US trading session. I have discussed previously how this can be a positive trait for ETFs; investors can use the ETF as a price discovery tool in terms of how those markets may perform when they re-open on their next business day.

For example, suppose we have a US-listed ETF that consists of only Japanese and South Korean stocks, and the calculated NAV is $100. Meanwhile in the United States, the equity market has had a very positive, strong trading session and investors feel that strong sentiment will carry over into Japan and South Korea’s trading sessions the next day.

It is very possible the ETF in this example could trade at $101, as investors expect the Japanese and South Korean equity markets to be up 1% the next day.

Even if the US market was able to perfectly predict what will happen the next day in Japan and South Korea and they do both rise 1%, the NAV will still be $100. As the ETF closed at $101, there will be a 1% premium.

2. Less Frequently Traded ETFs

This is almost the same conundrum in reverse. Often, the trading in newly listed products in particular can be sporadic, sometimes with only a couple trades per day or even none at all. In this example, the price of the underlying securities can keep moving while the ETF price does not.

Let’s look at an example of an ETF that holds only US underlying stocks and the last trade of the day is at 10:30 a.m. EST at a price of $99.50, which is in line with the price of the underlying securities at that time.  The US market then rallies the rest of the day, and the end-of-day NAV is $100. That ETF would have a discount of 50 bps simply due to the fact it did not trade closer to the official market close. This phenomenon can be exacerbated if the ETF does not trade at all on a given day as the closing price used in the premium/discount calculation is the last traded price, even if it is from a prior day.

Depending on the extent and timing of these premium/discounts, they can cause some performance differences between an ETF and its NAV.

However, these metrics are not indicative of any problems with the ETF and will usually revert over the next time period as the price discovery process continues and/or as the product starts trading more frequently throughout the day. Investors simply need to consider the trading best practices I have discussed previously.

Furthermore, investors should know what their ETF holds, which will help explain the possible drivers of any premiums or discounts.

David Mann’s comments, opinions and analyses expressed herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

This information is intended for US residents only.

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