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What Does It Mean When an ETF Is Trading at a Premium or Discount?
Understand the meaning
You’ve probably seen a news clip or come across an article stating that an ETF is trading at a premium or a discount. You know that premium means that it is likely trading above something, and that discount means that it is likely trading below something. What is that specific something? That specific something is net asset value (NAV). NAV is the net value of an ETF. NAV = (Assets — Liabilities) / Total Number of Outstanding Shares. Now that the something has been cleared up, let’s dive a little deeper into this.
Let’s say that there is an ETF called ABC. ABC’s current price is $100, and its NAV is $98. What does that mean? That means that ABC is trading at a premium compared to its NAV. On the flip side, if ABC’s NAV is $102, that means that it would be trading at a discount compared to its NAV. Essentially, if an ETF is trading above its NAV, it is trading at a premium. If it is trading below its NAV, it is trading at a discount. When the stock market is relatively calm, the price of an ETF tends to be generally close to its NAV. However, when the stock market is volatile, ETFs may experience rapid price changes due to market sentiment while NAV takes longer to adjust, resulting in premiums and discounts.
Premiums and discounts are typically corrected thanks to a mechanism known as creation/redemption in which the sponsor, typically the management, of an ETF can request. Creation is when an authorized participant (AP), typically a market maker, buys the underlying securities of an ETF to create more shares of the ETF to sell to the market to drive down an ETF’s price from a premium to be closer to its NAV. Redemption is when an AP buys shares of the ETF to redeem for the underlying securities to drive the price of an ETF up from a discount to being closer to its NAV.
ETFs generally trade close to their NAV, which is considered their fair value. When an ETF’s price starts to stray away from its NAV, creation/redemption can be implemented to drive the ETF’s price back to its fair value. With a better understanding of what it means when an ETF is trading at a premium or discount, you better understand a key product that is helping to generate long-term financial wealth for you.
