Introduction
ETFs trade on both the primary and secondary market. This means they trade intraday, one of the key benefits of the ETF wrapper.
Because of this intraday trading mechanism, an ETF’s live price may not be entirely in line with its net asset value (NAV) which is calculated at the end of each trading day.
If an ETF trades at a price above its NAV, it is considered to be trading at a premium, however, if it trades at a price lower than its NAV, it is trading at a discount.
Authorised participants, which are responsible for creating and redeeming ETFs, play a crucial role in keeping ETFs priced at fair value which, in calm markets, tends to be close to the NAV.
If demand for an ETF increases and a premium to NAV develops, authorised participants step in to create more shares and push the ETF’s price in line with the NAV.
If an ETF is being sold and a discount develops, authorised participants purchase ETF shares on the open market and redeem with the ETF issuers to reduce supply.
However, there are instances when fair value is not the NAV and authorised participants are unable to access the underlying securities needed to bring an ETF’s price in line with the NAV.
For example, if a stock market is closed and the NAV effectively becomes a stale price, an ETF can trade at a premium or discount to represent the fair value of the underlying securities which is known as price discovery.
This occurred when the Egypt stock market closed during the Arab Spring in 2011. The Market Vectors Egypt ETF (EGPT), which was the only way to access the Egyptian market, started trading at a significant premium to NAV as demand for Egypt exposure was high.
Furthermore, significant premiums or discounts can occur when markets are illiquid or more volatile.
When liquidity in the bond market dried up during the coronavirus selloff in March 2020, fixed income ETFs traded at all-time high discounts which reflected real-time prices in the underlying securities.
Price discovery
When the primary market cannot be accessed, ETFs effectively begin trading like close-ended funds because authorised participants are unable to create ETF shares from the underlying market.
Overall, ETFs tend to trade close to the NAV in most market conditions, however, there can be instances where large premiums and discounts can occur.
What is crucial is understanding why this happens and the price discovery role ETFs play when access or liquidity vanishes in an underlying market.
Key takeaways
ETFs trade throughout the day, leading to potential price differences from their end-of-day NAV. Premiums (higher price than NAV) and discounts (lower than NAV) can occur.
Market makers aim to keep prices close to NAV by creating/redeeming shares based on demand. This usually works in calm markets.
In situations like closed markets or illiquidity, NAVs may not reflect true value. ETFs then trade at premiums/discounts reflecting underlying asset prices, acting like closed-ended funds
