Learn how to navigate ETF premiums and discounts

In addition to the expense ratio, there are other costs that make up an ETF’s total cost of ownership (TCO), perhaps most notably the bid-ask spread that arises when ETFs are bought and sold on an exchange. Here, we will examine premiums and discounts, another piece of the TCO puzzle that can be confusing to navigate.

We’ll help dispel some of the myths about ETF premiums and discounts, explain why they can occur in the market, and provide insight on what to focus on to make informed investment decisions. We’ll also look at how they differ by asset class.

Throughout this discussion, two takeaways should loom large. First, the presence of premiums and discounts should not lead investors to avoid ETFs. Second, extremely volatile premiums and discounts can potentially erode longer-term returns significantly.

One demonstrable way to steer clear of relatively elevated ETF premiums and discounts is to avoid trading on days when markets are roiled. But if you have to trade in dislocated markets, you should know a thing or two about them.  

Fair value    

The value of an ETF is determined in a number of ways, each of which can affect an investor’s experience. First, there’s the net asset value (NAV). As with mutual funds, NAV is the assessed value of all of an ETF’s underlying securities based on their closing prices.¹

In other words, it’s the fund’s fair value. But unlike with mutual funds, ETF investors don’t transact at NAV.² Instead, ETF prices are determined by the market.

An ETF’s market price will therefore be the most important price for investors—the one at which they buy and sell shares in the secondary market. Since market prices are ruled by supply and demand, an ETF’s market price can naturally diverge from its NAV.

If there’s heavy demand from buyers, the price of an ETF can increase slightly above NAV, leading to a premium. Conversely, if there’s heavy sell-side pressure, the price can dip below NAV, resulting in a discount.

The creation-redemption mechanism

The beauty of the ETF structure is the creation-redemption mechanism, the engine that allows new ETF shares to be created in the market to meet client demand or redeemed to reduce supply should it wane. Creations and redemptions keep an ETF’s price in line with fair value and preclude severe premiums and discounts. As long as the mechanism is running smoothly, ETF pricing should stay near fair value.

ETF premiums and discounts do not always result in transaction costs, which makes quantifying these costs more difficult. The costs related to the premium or discount become more apparent when an investor sells. The biggest risk arises when an investor purchases an ETF when it’s trading at a substantial premium and then sells it at a substantial discount. This is why it’s more important to focus on the volatility of the premium and discount.

ETF A has an average premium of 18 basis points (100 basis points = 1 percentage point), and ETF B has an average premium of 0 bps (basis points). An investor looking at this data might assume ETF B is a better product.

This would be incorrect.

Although ETF A does have a larger average premium, the [A1] premium is more stable, which reduces the investor’s risk and potential costs. If investors buy and sell at a stable premium, the cost is likely to be predictable and relatively modest. As the graph illustrates, a client would buy ETF A at a 22 bp premium and sell at an 18 bp premium, incurring only 4 bps of transactions costs. So while it may seem a disadvantage to buy an ETF at 22 bps above its NAV, selling at a similar premium can offset this initial cost.

Conversely, ETF B has a smaller but more volatile premium, which exposes investors to the possibility of buying at a significant premium and selling at a significant discount. An investor who purchased at a 64 bp premium and sold at a 61 bp discount would incur 125 bps (1.25 percentage points) of transaction costs. Unlike ETF A, selling at a steep discount only adds to the initial transaction cost.

Again, a larger but stable premium is often preferable to a lesser, volatile one. The standard deviation of historical premiums is arguably a clearer way to estimate transaction costs than the average premium.

Differences among asset classes

Domestic ETFs

Domestic equity ETFs generally trade in line with NAV. Premiums and discounts are typically slight for a variety of reasons, including the lower cost of buying and selling the underlying domestic equities, the relative ease of pricing underlying stocks and ETFs simultaneously, and the lower fixed fees incurred.

In other words, pricing domestic ETFs is relatively straightforward and can frequently be achieved without too much deviation from NAV.

International ETFs

International ETFs may have more pronounced premiums and discounts. It’s more challenging to determine the fair value of the underlying constituents, partly because the markets where they’re listed may not be open during hours when U.S.-listed ETFs are trading.

Other costs may include larger fixed fees, higher commissions, stamp taxes and associated fees, foreign exchange hedging costs, and the imprecise nature of fair value factors. This makes the process to create or redeem international ETFs less precise, which translates to larger premiums and discounts.

Fixed income ETFs

Fixed Income ETFs usually trade at an inherent premium. Their NAV is based on the bid price of all the underlying securities in the fund, or the price at which the fund could sell all of its underlying bonds.

The ETF’s market price will typically be near the midpoint of all the underlying bonds in the ETFs basket.

This represents what it would cost market makers to buy the underlying bonds to create new ETF shares, though sometimes an ETF can trade up towards the cost to create new shares, realizing the full basket spread.

Key takeaways

Premiums and discounts are important components of an ETF’s TCO. Even though they don’t always result in transaction costs, they should be well understood to make informed investment decisions.

The critical lesson is that premiums and discounts vary by asset class, and their stability is considerably more meaningful than their size. A larger, but stable, premium is often preferable to a lesser, volatile one.

There are 23,400 seconds in a trading day—23,400 snapshots in time when an ETF could be trading at a premium or discount to its intraday NAV, or iNAV. That means that the premiums or discounts published at the end of each day only include the closing snapshot, comparing the official NAV to the closing price of the ETF on its primary exchange—not always an accurate depiction of where the ETF was trading during normal market hours.

In the end, ETF premiums and discounts are part of ETF trading and can work for or against you depending on where the price is—premium or discount—and on which side of the trade you find yourself—buying or selling.

So, it’s imperative to learn about them and not get caught on the wrong side when managing portfolios. Using proper trading strategies can help prevent investors from buying at a high premium or selling at a low discount in volatile market conditions.

1 Certain funds may apply a fair value pricing methodology that will set NAV at different levels than the underlying securities’ official closing value.

2 ETF investors have the ability to make NAV trades; however, these trades typically need to be placed by a high-touch trade desk and are often executed with a markup or markdown to the stated NAV depending on the asset class and trade direction.

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