What causes premiums and discounts in ETFs?

 

Ideally, an ETF should trade at a price that’s close to its NAV. 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 that is 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, authorized participants 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 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.
  • 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.

Many ETFs, notably domestic equity ETFs, have smaller premiums and discounts since they trade at the same time as their underlying market, which is also very liquid.

However, some ETFs tend to have larger or more constant premiums and discounts. We'll take a look at why premiums and discounts commonly occur in certain asset classes:

International ETFs | more

International ETFs may sometimes appear to trade at a premium or discount relative to their NAVs, but this is largely due to a difference in the trading hours for the ETF versus its underlying securities.

The underlying foreign securities in the portfolio—the basis for an ETF's NAV—may be closed for trading in their respective local markets while the ETF itself continues to trade, but market participants make bid and ask prices on international ETFs based upon those participants' estimates of where the underlying securities would be trading if their markets were still open. Because of the uncertainty of these estimates, the ETF may trade at a premium or discount to NAV.

Domestic bond ETFs | more

You often hear about premiums and discounts occurring in domestic bond ETFs. A major reason for the occurrence is the pricing difference between the ETF and the underlying bonds.

As shown in the illustration below, a bond ETF's end-of-day market price is calculated as the midpoint of the best bid and offer at 4 p.m., Eastern time, while the underlying bonds in the portfolio are valued at their bid prices. This pricing difference results in an inherent premium since the midpoint of the bid-ask on the ETF is typically going to be higher than the bid price of the underlying bonds.

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The level of premium or discount will also vary depending on the demand for the ETF relative to the flow in the market. As shown in the illustration below, the greater the relative demand to buy the ETF, the higher the bid-ask quote and thus the higher the midpoint of that quote. 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.

image

Now, bond 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 underlying securities could widen to reflect the current market situation, leading to larger premiums and discounts for bond 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; they end up manifesting themselves after the fact as part of the fund's NAV.

To put a fine point on it: premiums and discounts in bond ETFs are largely a reflection of the externalization of investors' transaction costs.

 

Things 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:

Bonds

  • 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 have larger premiums and discounts.

Equities

  • 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.
 

Premiums and discounts and Vanguard ETFs

Vanguard offers the premium/discount history for each of our ETFs in the Investment Products section of our website. Just choose a product, select Price & Distribution, and view the Premium/Discount chart.

For international ETFs, Vanguard discloses the effect that fair-value pricing has on performance in the Investment Products section of our website. Just choose an international product, select Performance, and view the Difference due to fair value pricing.

Consider using limit orders when placing trades since you'll be able to determine the maximum price at which you'll execute an ETF trade.

Learn more about limit orders

All investing is subject to risk, including possible loss of principal.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

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