29 Jun ETF Premiums and Discounts in Volatile Markets
by Justin Lowry, CIO, Global Beta Advisors
Have you found yourself wondering how the volatility of recent months has affected the prices of exchange-traded funds, and more importantly how this impacts your client’s portfolios? While actual value and current prices are generally pretty close when markets are calm, they may diverge significantly during volatile market conditions. To better understand what this means for investors, let’s answer a few basic ETF questions.
What are ETF Premiums and Discounts?
The actual value of an exchange-traded fund (ETF) is measured by its net asset value (NAV). This figure represents the value of each share’s portion of the ETF’s underlying assets. ETFs calculate their NAV after the markets close each day.
ETFs also have a current market price on the exchange on which they trade. This is the price at which shares can be bought or sold by investors during trading hours. It may differ from the fund’s NAV slightly or significantly depending on market conditions. Brokers will create a market for an ETF. Each ETF has a broker that primarily makes markets for their ETF, who are called Lead Market Makers. The Lead Market Maker is responsible for creating liquidity for the fund. The market maker generally tries to create a bid and an ask in and around the fund’s intra-day NAV. However, if markets become overly volatile, market makers will shift that spread according to the futures market in order to protect themselves against big market movements. This phenomenon can influence whether a fund will trade at a premium or discount relative to its NAV. If the futures market is indicating large downside in the market, the market maker will price the fund below the fund’s intra-day NAV. If the futures market is indicating large upside in the market, the market maker will price the fund above the fund’s intra-day NAV.
Additionally, an investor’s aggressive trading can quickly drive up the price of an ETF on the market. As a result, the ‘current’ price could rise higher than the ETF’s NAV. In this situation, the ETF is trading at a premium to its NAV. On the other hand, aggressive selling of an ETF’s shares can drive down the market price. If that price falls below the fund’s NAV, it will be trading at a discount. This is why it is important for investors to be deliberate when buying or selling shares of an ETF. Most ETFs do not trade large share quantities on a daily basis; however, the underlying securities of the ETF may be highly liquid. It is important for an investor to work with their broker about an execution strategy when purchasing or selling an ETF. This can be done very efficiently.
Is NAV Always the Best Indicator of an ETF’s Fair Value?
The simple answer is no. When investing in ETFs, NAV may not be useful for certain asset classes during volatile market periods.
Consider bond ETFs, for example. Bonds trade off-exchange or over the counter (OTC) at negotiated prices, and because of the bond market structure, they may not trade actively on a given day. When an ETF that holds bonds calculates NAV, the pricing for some of the securities held may utilize estimates or theoretical pricing methods such as changes in interest rates, credit spreads, or other factors.
Transactions occur when buyers and sellers agree on a price. For this reason, bond ETFs intraday market prices may provide a more accurate picture of the value of the underlying bonds than the NAV, which was calculated after the prior day’s closing of the market.
Fortunately, most ETFs are structured as open-end funds, with authorized participants (APs) creating and redeeming shares on any given day. APs keep the ETF’s market price close to the NAV in order to manage the short-term risks and costs of supply and demand dynamics. For this reason, most ETF premiums and discounts are temporary.
Do Premiums and Discounts Matter for Long-Term Investors?
Simply put, ETF premiums and discounts during volatile markets should be of little concern for long-term investors. Assuming your client portfolios maintain their ETF positions throughout the period of market unrest, they will likely realize the fund’s NAV performance over time with little impact on portfolio performance. Outsized premiums and discounts tend to subside once the market calms.
ETF investors worried about the recent period of market stress driven by concerns surrounding the COVID-19 pandemic should know that the U.S. Federal Reserve is directly buying several forms of fixed-income securities (including corporate bond ETFs) in an effort to provide liquidity to the broader fixed-income market. Additionally, the generally asset buying program by the Federal Reserve during the pandemic has restored market efficiency, allowing investment vehicles such as ETFs to trade more in line with their intrinsic value.
In Summary, Rely on ETF Trading Best Practices when Markets are Volatile
Market volatility can be stressful, but it’s not a reason for long-term investors to sell their ETF shares. Communicating this to your clients with regard to their portfolios can provide the reassurance they may need to feel confident about following your portfolio recommendations during periods of market volatility. We urge you to review ETF trading best practices whenever panic strikes. These include avoiding making trades near the open or close of the market and using limit orders rather than market orders when making ETF purchases or sales.